A close friend and respected investor once explained to us that short term comfort only comes at the expense of long term performance. We could not agree more, but conceptual agreement does not make it any easier to sit alone in the corner while the music is still playing and everyone else at the party is still dancing. Just ask Chuck Prince, former CEO of Citigroup, and a very good dancer. As comfortable as it may seem, it is always dangerous to dance with the consensus. By definition, once an investment theme has become consensus, the crowd has fully exploited the opportunity, leaving the trend vulnerable to a reversal. As Sir John Templeton advised, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”
Therefore, it is always important to assess market sentiment as it relates to popular opinion. Today, we are increasingly concerned with the number of investors who agree with our constructive stance on emerging markets, but the critical question remains – Is it time to bet against the crowd given current conditions? Regrettably, determining whether or not a story has been fully discounted by the market is a highly subjective exercise. And a consensus may not always be wrong as the old adage reminds us – right on the trend, wrong on both ends.
Our conclusion today is that we suspect the path of least resistance for emerging markets remains higher although positive fundamentals are generally recognized. The developing world economies are structurally stronger than their G7 counterparts. Without the handicap of a politicized banking system and the drag of an overleveraged consumer, these economies are rebounding at impressive rates. Under “normal” circumstances, this would justify interest rate levels at least in line with underlying GDP growth. However, within the context of today’s New Normal, the actual level of interest rates is being held down by G7 central banks. As long as China and friends continue to peg their currencies to the Burning Buck and as a result, continue to import US monetary policy, short term interest rates in the emerging world will remain at levels far below GDP growth.
This is exceptionally bullish for emerging market assets as suppressed rates will ultimately over-stimulate growth, driving risk assets higher along with local currencies. While it may still feel premature to consider the next financial mania as the ashes of the Credit Crisis are still falling, the evidence suggests that this is exactly the time to do so. Bull markets flourish on easy money and credit, often encouraged by policy responses to the previous bust. This time will be no different. The Great Reflation will inevitably spark another financial mania and massive bubble. Societe Generale just published an excellent piece which outlined Charles Kindleberger’s “anatomy of a bubble” which we have reproduced below as a roadmap for investors:
Stage 1 sees “displacement.” Frequently, this comes about through the introduction of a new disruptive technology (e.g. canals, railways, or the internet) although Kindleberger says it doesn’t necessarily have to come from such an innovation. It can arise on the back of greater market liquidity through, for example, financial deregulation.
Stage 2 is the “boom.” A convincing narrative gains traction (e.g. Asian economies are “miracle” Tiger economies; the Internet will change the world; sub-prime mortgages help financial institutions diversify risk). Price movements which seem to confirm the narrative are stoked by credit creation.
Stage 3 is “euphoria.” In the words of Kindleberger, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” This greed sucks people who wouldn’t normally involve themselves in such practice into the mania. More and more people seek to become rich without understanding the process involved. Rationality becomes stretched and increasingly fanciful notions excuse what would ordinarily be considered irrational behavior.
Stage 4 sees the “crisis.” The insiders originally involved start to sell. Prices level off and begin to fall. Those who bought at the top find themselves pushed out first and their selling eventually cascades down through the remaining believers. Speculators realize prices can no longer rise and the rush to exit is on. To the extent that leverage was used to finance any purchases at irrationally overvalued prices, savage price declines put banks in trouble too.
Stage 5 sees “revulsion” where prices likely overshoot fundamental values on the downside. Scams and frauds are uncovered. Scapegoats are found for the financial distress caused. The object so richly desired as the bubble inflated becomes an object of ridicule and disgust, along with anyone or anything associated with it.
The most obvious implication today is the growing prospect for an emerging market bubble, which has all of the elements described above. It qualifies as a “new era” candidate with displacement in the making for some time, as BRIC share of global GDP has grown significantly in the past quarter century. It is now easy for investors to allocate to the emerging world with the growing number of liquid ETFs available in the marketplace today. Decoupling is slowly coming back in vogue and valuations remain fair, suggesting that as prices move higher, money will follow and push them still higher. Finally, the secular nature of this shift, combined with the cyclical stimulus in place today, make the prospects for such a move that much more attractive.
Emerging Markets share of global GDP has risen from 21% to 37% from 1990 until today. Their share of Market Cap is still just 12% of world markets. To get a sense of what a bubble looks like, in 1990 Japan represented 40% of the world’s entire market capitalization!! We have a long way to go here.
For additional thoughts on emerging markets, we have reproduced our First Quarter 2009 letter to investors below.
Broyhill Letter (Q1-09)