Societe Generale has released a massive new report that advises investors on the medium term future of the markets. The report goes through the effects that Federal Reserve policy will happen all over the economy and the results of a European recovery and U.S. deflation. The most interesting part of the report is possibly the section on emerging markets.

Emerging market performance in the medium term is clouded because of the complexity of Federal Reserve policy changes, but the analysts are certain that the end game of the current financial crisis will take place in the emerging markets. China, India, Brazil and Russia, as well as the smaller players, are vulnerable.

A simple story on emerging markets

The analysts relay a narrative about the financial crisis that is beautiful and simple. The crisis started in the United States where credit market problems triggered liquidity issues, which triggered a total economic and financial crisis.

Emerging Market

That crisis changed the nature of the European sovereign budget, which lead to the near inevitable debt crisis in the Eurozone and the continued economic problems on that continent. Those problems have prolonged issues in the United States because of lack of demand.

The demand problems have helped prolong the crisis. The inevitable result is problems in the emerging market, according to the SG report. The same pattern has occurred in all three economies, but the timeline is off by two to three years.

EM FLOW

Structural economic problems are followed by massive asset price declines and worries of complete collapse. Those worries are followed by a bigger-than-expected bottom where asset prices are flat. Eventually asset prices start to climb again. That’s happening in Europe right now, just as EM looks to be weakening.

Betting on EM collapse

Investors swayed by the narrative have several options. The first is to pull out of any wide based EM fund or other diversified EM investments. Not all EM countries will see the same effects, but the effects will be felt across the entire market, according to Societe Generale.

EM balance

Investors will be obligated to pick between the EM countries if they want to keep investing in the markets. The above graph shows the nations that are seeing problems with their government spending and those with currency problems. The graph shows that those countries might see big problems in the period ahead.

Two of the biggest emerging markets, India and Russia, are in the red ellipse. Countries in the red area have problems with government spending and currency exchange rates. Brazil is just outside the red ellipse, but has inflation problems, and China is just outside the green ellipse of relative safety.

Election EM

One of the easy to spot events that are likely to cause difficulty in specific emerging markets is the democratic process. Those countries with elections coming up are going to see a less effective political process. That means that politicians will be less willing to make tough decisions in the face of an economic crisis.

EM assets

According to the SG argument, EM assets have further to fall if the current conditions persist. Careful investors will want to sty out of the emerging markets entirely, but those that still want to gamble on emerging markets will need to pick their bets carefully.

Societe Generale essentially advises that investors stay away from emerging markets. The effects of the end of soft money in the United States will pull money out of the riskier markets. The medium term future of the markets is difficult to predict. “Stay away” is certainly the safest advice, but it may not suit all investors.