Yesterday's Winners, Today's Losers

06/19/2008 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

Just a few months ago, international and emerging markets investing were all the rage.

Investment advisers and Wall Street firms urged investors to hop on the train, and they obliged by pouring billions of dollars into emerging markets stocks, funds, and ETFs.

But now, the train has come to a screeching halt, for one principal reason: oil.

The soaring price of crude has caused a sea change in world markets, unleashing inflation and seriously wounding economies that last year seemed unstoppable. It has helped trigger bear markets in once-red-hot India and China and sent the BRIC countries (which also include Brazil and Russia) hurtling in opposite directions. And for the first time in a generation, it has created a class of “have” and “have not” nations based on whether they produce or consume crude.

It also puts the governments of these countries—some democratic, some not—between a rock and a hard place. They can keep subsidizing gasoline and watch their carefully built-up surpluses evaporate or they can remove price controls and face popular upheaval. They can keep promoting economic growth and let inflation get out of hand, or they can raise interest rates sharply and watch their whole growth story undermined.

“We are testing the resilience and capability of many of these policy makers. We may be at a turning point,” says Robert von Rekowsky, manager of the Fidelity Emerging Markets fund (in which I hold a small position).

That’s true for investors, too. Emerging markets have been among this decade’s stellar performers. Morningstar’s diversified emerging markets fund category has soared at a 29.2% annual clip over the past five years, but it has fallen by nearly 7.5% thus far in 2008. I expect many of these markets to underperform for years to come.

But Latin American funds have gained nearly 10% this year, while Pacific Asia excluding Japan has lost more than 20%. Latin American funds are heavily invested in Mexico and Brazil, both net energy exporters. Asia is home to some of the thirstiest consumers of oil, accounting for some 70% of the growth in world energy demand.

As the table shows, stock markets of net oil exporters (which export more than they import) have done far better than those of net importers. Russia, the world’s second largest exporter, and Brazil, which is energy independent, have been among the top performers, while oil exporters Mexico, Canada, and Norway have posted either small losses or modest gains during the past 12 months.

The Haves and Have Nots
Stock Performance of Oil Producers & Consumers
  Net Oil Exports 2006 Stock Mkt. Performance
  (in million bbls./day) June 29, 2007—June 13, 2008
Russia* 6.57 14%
Norway 2.54 -3%
Mexico 1.68 -2%
Canada 1.01 6%
Brazil 0.04 24%
India** -1.69 4%
Germany -2.48 -16%
China*** -3.44 -25%
Japan -5.1 -23%
US (S&P 500) -12.22 -10%
*RTS Index, in rubles
**India's Bombay Sensex index has lost 25% in 2008
***Shanghai Composite Index
Sources: Energy Information Administration, Yahoo! Finance

But the “have nots” have had their clocks cleaned. Big importers Germany, China, and Japan have suffered hefty double-digit losses in the past year, while India has seen its stock market lose one-quarter of its value in 2008. The US market has actually done pretty well given its status as the world’s premier energy guzzler.

And the chart below reveals a “decoupling” far different from what strategists envisioned last year.

I’ve plotted the performance of the US Oil Fund (Amex: USO), an exchange traded fund that tracks crude oil futures, against that of several markets. Notice China in particular: The orange line representing the Shanghai Composite index kept rising along with crude at first, but starting in November 2007 it started falling sharply as oil advanced, and now has been the worst performer among all these markets. The rising price of crude is clearly the main culprit.

The Chinese government, like that of other Asian countries, has capped prices of energy used by consumers, like gasoline and kerosene. As crude soared, though, it and other governments had to subsidize the losses of refiners like Sinopec (NYSE: SHI), which bought crude at higher prices but sold energy domestically at artificially low prices. That has cost their treasuries tens of billions of dollars.

So far, the governments of Taiwan, Indonesia, and Malaysia have raised fuel prices, and India did as well, prompting an outcry from opposition parties. On Thursday, China finally succumbed, as its government announced it will let fuel prices rise as well.

But the horses may already have fled this barn. Rising energy costs have triggered big price increases in food, fuel, and materials of all kinds. Crude’s doubling in price since spring 2007 and very rapid money supply growth in many emerging countries have combined to drive inflation dangerously high.

Vietnam now has inflation of 25%, and its fledgling stock market—last year’s rising star—has lost two-thirds of its value in 2008. Pakistan and Sri Lanka’s inflation are running at 20%, Indonesia is at 10%, while inflation is over 8% in China and India. Food and energy costs account for over a third of consumer price indexes in many of those countries.

If the trend continues, it’s bad news for many of these markets. “Inflation is generally a P/E compressor,” says Alec Young, global equity strategist for Standard & Poor’s. That means it drives stock prices down. Just think of what US stocks did during the double-digit inflation of the 1970s: nothing.

Absent any sustained drop in energy prices, nothing is about what I expect from most emerging markets over the next couple of years, excluding perhaps Brazil (which has discovered a potentially huge deepwater oil field) and other energy exporters. Last October, at the peak of China’s mania, I recommended selling China and reducing exposure in emerging assets to no more than 5% of investable assets.

Young says S&P cut its recommended emerging markets allocation to about 3% (out of a total international exposure of 15%). That sounds about right to me, if you want to be in this area at all.

These countries will recover from the current crisis and ultimately resume their strong growth. But the risks, which promoters of these vehicles chose to ignore, have returned with a vengeance.

“I’d take my mother out of emerging markets and put my brother into emerging markets,” says von Rekowsky.

Maybe so, but anyone who’s in these markets should expect that investment to be dead money, at best, for some time to come.

Howard R. Gold is executive editor of The opinions expressed here are his own and do not necessarily reflect the views of InterShow or

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