In horse racing, a match race is when two horses race against each
other. One of the most famous such races happened at Pimlico, when
Seabiscuit beat War Admiral in November 1938.
In markets, one of the most watched and ongoing match races is the one
between Emerging (or developing) Markets and Developed Markets. The
former include China, India, Brazil and others. The latter include the
US, the EU and Japan. Which one do we bet on and when?
It’s a particularly good question now, as we pick through the
smoldering ashes of the 2008 bust. Emerging markets have had a hot 10-
year run, even if you include the crackup in 2008. In fact, even if you
had invested in the MSCI Emerging Markets ETF (NYSE:EEM) on Jan. 1,
2008, you would be sitting on a profit today. By contrast, the S&P 500
Index has delivered a double-digit loss over the same timeframe.
The emerging markets have snapped back surprisingly quickly. As
Jonathan Anderson, a UBS strategist put it, “Not even the worst
economic crisis in the postwar era has been able to derail [them].” In
financial markets, ideas, like thoroughbreds, run hot and cold. Past
performance doesn’t necessarily decide the issue any more than it does
in horse racing. But it turns out there is a pretty reliable way to
handicap the race between Emerging and Developed Markets.
The “handicapper” in this case is the aforementioned Mr. Anderson, who
wrote about his findings in the Far Eastern Economic Review. His title,
“Emerging Markets Poised to Perform,” hints at his conclusion.
It all comes down to those old financial constructs called balance
sheets. In essence, a balance sheet shows you what you own versus what
you owe. These are snapshots in time, a measure of financial health,
like an EKG of one’s heart rate. You can often spot trouble here before
it becomes fatal.
In my investment services, I always seek out companies with strong
balance sheets – the sorts of companies that own much, but owe little.
Enterprises like theses have the ability to withstand adversity better
than those with weak balance sheets. A strong balance sheet also means
that a company can fund its growth independently and more securely,
without having to rely on fickle lenders.
As investing star, Martin Whitman, wrote in his most recent shareholder
letter: “Don’t invest in the common stocks of companies which need
relatively continual access to capital markets, especially credit
markets… Even the strongest, best-quality issuers can be brought
down, or almost brought down, if they continually have to refinance.”
Unfortunately, many investors learned this lesson the hard way during
last year’s severe credit crisis.
As it turns out, balance sheet strength is also very important for
entire nations. But that’s hardly a surprise. Countries that owe a lot
of money tend not to grow as much or as reliably as those with healthy
balance sheets. Anderson created a “stress index” to measure the
financial health of entire nations. A country with high debt levels and
deficits earns a high stress index score. He then plotted this index
(inverted) against a rolling average of GDP growth, a rough measure of
Guess what? There’s a close connection between the two.
So one way to explain the growth of emerging markets is to consider the
strength of their balance sheets. When they have healthy balance
sheets, they grow faster than when they have weak balance sheets.
You can see that the last time the emerging markets had a long stretch
in the sun was in the 1960s and 1970s. Emerging markets grew 5% or
better. As Anderson notes, not a single emerging market – not Africa,
not even the Soviet Bloc – failed to post 5% annual growth during this
time. And you’ll also note that the balance sheets were healthy.
As a result, emerging markets sailed through the first global oil shock
in 1973-75 without much trouble. The developed world, by contrast,
suffered the pain of a deep recession. Investors who stuck with their
emerging market stocks throughout this period reaped big rewards.
According to Anderson, “Between 1965-1980 the dollar-adjusted return on
nascent equity markets in Mexico, Hong Kong, Taiwan, Brazil, South
Africa and other lower-income nations ran into the hundreds of percent
– while indexes in the US and Europe were essentially flat over the
same 15-year period.”
Of course, as I say, these things run hot and cold. The emerging
markets “imploded” after the 1980-82 recession. A dozen different
countries reported inflation rates north of 100%. As Anderson points
out, 20 currencies lost 50% of their value each year. From 1980-99,
emerging markets struggled mightily and barely grew. And as you see
from the chart, their balance sheets went south as well.
Emerging Market returns during this period were poor overall. A dollar
invested in emerging markets in 1990 was still worth only about a
dollar 10 years later. In 2000, though, the game changed again.
Emerging markets opened up. They cleaned up their debts. And the
emerging markets went on a tear that continues today.
In general, emerging markets still have healthy balance sheets today.
In fact, they are as strong as they’ve been in 50 years. At some point,
that will swing the other way, as these things always do. At some
point, there will be too much debt and too much leverage. But for now,
that condition seems a ways off.
As Anderson concludes, “All the preconditions are in place for a
protracted period of strong economic growth.” He guesses 5-6%, which
would crush the Developed World’s growth rates. In fact, the superior
(and diverging) growth rates of the Emerging economies are already very
First up, take a look this graph, from The Economist, which shows the
industrial production of emerging Asia compared to the United States.
Looks like Asia is recovering pretty well. The chart above clearly
illustrates the “decoupling” that became such a hot topic of discussion
last year. The idea was that the Emerging markets would not necessarily
follow lockstep with the Western countries.
The Developed World suffers through what Richard Koo, the chief
economist at Nomura Research in Tokyo, calls a “balance sheet
recession.” The Western world suffers from too much debt. That fact
shifts the focus from making profits to repaying debt, according to
Koo. Debt repayment will continue until the West repairs its balance
sheets, a process that takes years to correct, as Japan’s long
So the same dynamics that make emerging markets look good, work in
reverse for the Developed World. According to Anderson’s model, the
stressed balance sheets of the Developed World predict slow growth.
As investors, then, we’ll have to continue to look to the emerging
markets for growth. The market never ladles out its rewards evenly,
though. To drill down further, the big winner is really Asia and its
big markets of China, India and Indonesia.
Anderson estimates that these regions could grow 7% or more annually,
well above the tepid rates of developed markets and better than most
emerging markets. “This is a very hefty gap,” he writes, “and one that
is very likely to continue to reward investors who take advantage of
for Markets and Money