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Emerging Markets on the Rebound? More Like a Train Wreck

Many analysts have turned bullish on emerging-markets equities, arguing that markets have priced in an overly bearish outlook for the next 12 months. They claim that a moderate acceleration of the developed economies will, as in the past, propel a robust acceleration of the EM sector. Don’t buy it. You would be wiser to lighten up on EM positions or, if possible, to liquidate them entirely.

Expectations for EM economic performance have fallen in recent years, but they remain excessively optimistic. This sector is on the verge of profound, secular economic transitions. Emerging-markets countries face chronic, sometimes severe economic weakness and persistent financial instability over a number of years, even if a few of them manage to buck the trend. Despite the epic nature of the transitions slowly getting under way, they are largely unnoticed by markets because conventional economics provide little understanding of the forces behind them. The nature of these adjustments becomes vivid, however, when we turn to a financially oriented approach focusing on the sources of business profits, the primary driver of economic activity.

From the perspective of gross domestic product, an emerging-markets economy can offset the negative effects of stalling export growth and falling investment through growth in consumer spending. The problem with this scenario is that profits would fall, undermining business expansion. Business doesn’t profit from an additional dollar of revenue if it also pays an additional dollar in wages. For an EM economy to maintain private sector profits, it would need a great surge in investment by firms serving domestic markets, a dramatic reduction in saving by households or both.

The profits perspective highlights three critical points about the emerging-markets sector:

• The EM sector became overly dependent on favorable net exports and booming investment heavily skewed toward export capacity.

• Exports have settled onto a much lower and flatter trend than before 2008. Excess capacity has ballooned, yet investment is just starting to roll over and faces a historic decline.

• The EM economies cannot, as widely believed, simply shift to reliance on domestic markets. To offset weakening exports and investment, they would need to rapidly crank up the other profit sources, but most face overwhelming obstacles to such a change.

Most of the EM countries that were able to grow like mad in recent years did so by exploiting a unique combination of huge labor cost advantages, imported production technologies, new information technologies that facilitated the global decentralization of many corporations and foreign capital. For an emerging-markets country today to rapidly build a more domestically focused economy would involve risky investments in fledgling domestic markets at a time when stalled exports, narrowing profit margins, slowing economic growth, capacity gluts and uncertain labor markets are inducing public anxiety. Moreover, these domestic profit sources need to be financed, requiring a tremendous acceleration of domestic credit. The financial sectors of most emerging-markets economies are inadequate to meet such credit needs.

The export boom model, which drove the EM sector until the 2008 downturn, has become unsustainable; the pressures for adjustment are pushing these countries toward recession and serious financial complications. The question is not whether the breakdown will occur but when.

China is a special case. It had already been overshooting on capacity before 2008 and now has frighteningly large excess capacity and debt-quality problems. China is unique among EM countries, however, in having a high degree of financial independence, reflecting restricted capital markets, trillions of dollars in reserves, control of its currency and an unchallenged government with unlimited legal authority. Since 2008, China has been able to expand the profit sources directly, with vast government fiscal stimulus, and indirectly, through aggressive credit policies that induced more investment in domestic real estate, industry and even consumption. Unfortunately, the cost has been huge: a soaring private debt ratio (which makes the U.S. 1984–2009 debt boom look mild by comparison), increasingly daunting overcapacity and severe environmental and social consequences.

China can delay its eventual financial and economic crisis only by making the imbalances worse. The rest of the EM countries are on a slow-motion train wreck that will unfold faster or more slowly based on a variety of global factors beyond their control. This drama may play out in a number of ways, but none of them are terribly encouraging for EM investors. • •

David A. Levy is chairman of the Jerome Levy Forecasting Center (www.levyforecast.com), a macroeconomic research and consulting firm.