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Emerging Markets = Imploding Markets?

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Goldman Sachs released an institutional research report last week titled “Emerging Markets: As the Tide Goes Out,” in which they warned that this area of global growth will not only continue to disappoint next year, but for a surprisingly long time.

In fact, the report predicts “the strong possibility of significant underperformance and heightened volatility over the next five to 10 years.”The authors recommend that investors with just a “moderate” tolerance for risk cut their EM exposure by at least one-third, from 9 percent to 6 percent of overall portfolios.The scope of their timeline for EM underperformance surprised me because I thought that global growth over the next decade would be driven by billions of EM citizens aspiring to urban middle-class lifestyles.

From a CNBC.com article summarizing the GS view…

“Goldman Sachs used the 59-page report to argue that growth in emerging markets from 2003 to 2007 was a result of specific economic circumstances that aren’t likely to be repeated; the political and economic reforms needed to improve growth are too painful to undertake.

Common themes in Goldman’s pessimism on countries like China, Brazil and Russia include overinvolvement of governments in their economies, increasing reliance on commodities and unfavorable demographic trends.”

Goldman notes that China has five main problems…

1. Severely imbalanced growth
2. Weakening demographic profile
3. Financial repression that has distorted allocation of capital
4. Growing pollution that has endangered the health of its population
5. Antiquated household registration system known as ‘hukou’ that has hampered access to education and social services

And an even bigger China bear growled last week too. According to a Bloomberg article, when Deutsche Bank equity strategist John-Paul Smith looks at the country, he says he detects some of the same signs of a financial meltdown that led him to predict Russia’s 1998 stock market crash months in advance.

“China’s expansion is being fueled by soaring corporate borrowing, a high-risk model that needs to be replaced by the kind of free-market measures and budget cuts that fed Russia’s growth in the aftermath of the country’s default and subsequent 44 percent monthly tumble in the Micex Index, Smith said.”

I think this China/EM question will be one of the top 2 or 3 investor topics of 2014, because further equity weakness and possible financial/systemic issues, as repeatedly highlighted here by Tracey, could ripple over to our shores.

I have two questions for you…

1) Do you think Goldman is being extreme with the 5-10 year underperformance call for EM? Read their list of China’s “five main problems” again before you answer because the demographic issue might be the linchpin we hadn’t considered, on top EM governments’ biggest challenge that “the political and economic reforms needed to improve growth are too painful to undertake.”

2) In the most optimistic light, how long can the Chinese government prevent or postpone systemic financial fault lines from becoming a mega-quake? Clearly there will be growing pains in a rapidly emerging economy like China’s and it seems like the variables for their central bank to control are far more complex than the ones our own Fed faces.

Few investors believed the Fed could pull off what they did in the last 5 years without creating run-away inflation. Our faith in PBOC wisdom and skill must surely be far lower, or cloudier.

Let’s pick up where Tracey’s China in a Credit Crisis left off and keep this important discussion going for the next few months — at least until I revisit it!

ISHARS-EMG MKT (EEM): ETF Research Reports

ISHARS-BRAZIL (EWZ): ETF Research Reports

ISHARS-CHINA LC (FXI): ETF Research Reports

NASDAQ-100 SHRS (QQQ): ETF Research Reports

SPDR-SP 500 TR (SPY): ETF Research Reports

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