Ken Solow | February 7, 2011
One of the best known investment themes is that the growth of emerging markets like China, India, Brazil, and Russia will support global growth and actually contribute to the earnings prospects of U.S. corporations, which will help to sustain the current bull market. The idea that these emerging economies can sustain their economic growth at a much faster pace than old or developed economies is called the theory of “decoupling.” The emerging countries have stronger balance sheets, faster growing populations, very low costs of labor, and other well documented advantages that support GDP growth rates that are multiples higher than in Europe, Japan, and the U.S. My own seat-of-the-pants review of various public pension plans and retail client accounts reflects this new found optimism in the prospects for the emerging markets. I have observed that some portfolio asset allocation targets have higher percentage weightings in the emerging countries than they do in the U.S., a situation that was unthinkable a decade ago.
However, this year there has been a subtle, or lately, not so subtle shift in the consensus view of investment prospects for the emerging countries. In the short-term at least, the thinking is that these countries could very well under-perform the U.S. The reason is that the business cycles for these economies seem to be slightly out of sync. The U.S. economy remains in a below trend economic recovery from the Great Recession where there are several well recognized structural headwinds to growth. The most well known concerns are relatively high unemployment, shaky residential real estate values, suspect bank balance sheets, and a high amount of structural debt, including problems at the consumer, federal, and state levels. U.S. policy makers have responded with an expansionary response in terms of both fiscal and monetary policy. The result is an ongoing fiscal deficit (short-term bullish), 0% Fed Funds rate, steep yield curve, and a bloated Fed balance sheet. The good news is that the consensus believes that all of this bullish policy response is kind of a free lunch, because core inflation in the U.S. remains very low. Investors get to eat the results of excess liquidity in terms of higher stock prices and record profit margins, with little risk of higher interest rates and inflation… at least for now.
On the other hand, emerging markets seem to be well into the inflationary part of the cycle. In the case of China, where policy response is limited because their currency is pegged to the dollar, the result has been higher interest rates and higher bank reserve requirements. The fear is that commodity driven inflation is now a real problem. Food inflation, coupled with concerns about a Chinese real estate bubble, have investors worried. That caution has been playing out over the past year as emerging country stock prices have begun to trail the U.S. rally noticeably. We are currently trimming our emerging market allocations in Pinnacle portfolios. As always, it is somewhat unnerving to invest alongside the consensus. But it seems reasonable to us that the current headwinds facing emerging market investors are worth acknowledging by reducing our asset allocation.