I observe market sentiment is not where it was, but we called for an advance of gargantuan proportio...
Emerging Markets in 2013: Outperformance AND Volatility
01/18/2013 8:30 am EST
That was enough to send Japanese stocks down 2.6% on the day?
Welcome to the wonderful world of hot money, 2013-style. So far in 2013 we’re looking at a market that doesn’t have any confidence that the trend of this moment will be the trend of the next moment. And that is, therefore, constantly sloshing toward the opportunity of the minute or away from the possibility that a trend has peaked. I think these sloshes will make emerging markets—with their smaller market capitalizations than the United States, Europe, or Japan—especially volatile. Which, since these are the markets that look poised to do best in 2013, makes for some very tricky footing for investors in the year ahead.
Let’s take a slightly more detailed look at what happened in Japan and then see how these dynamics apply to the rest of the global stock market.
The rally in Japan is all about the yen.
There really isn’t anything else to get very excited about. The Japanese economy is in recession and the World Bank forecasts that GDP will grow by 0.8% in 2013 and 1.2% in 2014. The economy operates well below capacity with the output gap (the difference between the economy’s full capacity and the rate at which it runs now) at 5% to 7%. The debt to GDP ratio is 240%, the highest in the developed world, and with tax revenue at a 24-year low, the government spends 200 yen for every 100 yen it takes in. The population is aging—23% are expected to be over 65 in 20 years, up from 12% now—and shrinking with Japan’s population forecast to fall to 90 million in 2050 from 128 million now.
One bit of black humor making the rounds of demographers in Japan: On current trend in 600 years there will be 450 Japanese left. And those Japanese will be markedly poorer. Japan’s 5% unemployment rate is low by international standards but high in comparison to the country’s pre-1991 unemployment rate of 2% to 3%. Average annual salaries have declined for every year since 1999 and are now down 12% in all. About 34% of the labor force now works in part-time or contract jobs, up from 20% in 1990. In 2009, according to government statistic 15.7% of Japanese, including 14% of children and 21% of the elderly, live below the poverty line.
Clearly, you don’t put money into Japan to profit from the medium or long-term trends. (That there will be a long term is due solely to the extraordinary frugality of past generations of Japanese savers. The country is still sitting on $19 trillion in savings.)
You do, however, put money into Japanese stocks—especially those of Japanese exporters--in the short run because of the decline in the yen and because of projections of a continued decline. The yen has dropped by 14% against the U.S. dollar since October. Not exactly a small thing when Toyota Motor (TM) figures that every 1 yen swing against the U.S. dollar produces a $397 million swing in annual profit for the company. At Nissan Motor (NSANY) the shift between a recent 89.21 yen to the dollar versus the 2012 average of 79.82 yen to the dollar is worth a 34% increase in profit.
No wonder shares of an auto exporter such as Mazda Motor (MZDAY) are up 114% from October 30, 2012 to January 16 2013. And no wonder that global cash started to chase hitherto scorned Japanese equities. Cash flow into Japanese-domiciled investment trusts turned positive in October for the first time in two months.
The problem, though, is that almost everyone putting money into Japan is doing so while asking, “When does this end?”
The yen, which closed at 88.31 to the U.S. dollar on January 16 could easily go to 90 or with more difficulty to 95 or even 100, but the trend isn’t going to last forever. There are major forces pushing back against the campaign of the Shinzo Abe government to weaken the yen. Every decline in the value of the yen against the dollar increases Japan’s bill for dollar-denominated oil and natural gas. Every drop in the yen takes another bite out of already stressed Japanese workers and consumers. Whatever the willingness of the Abe government to pile debt on top of debt to weaken the yen and revive Japanese growth, its capacity to do so has real economy limits. And it’s the knowledge of those limits that gave the relatively gentle comments about the costs of a weak yen, the power to move stock prices in Tokyo.
And, of course, because the money that flowed into Japanese stocks in order to take advantage of a falling yen really has no belief in Japanese stocks or the Japanese economy in even the medium term, it has no loyalty to Japanese markets. Given the slightest signs that the short-term party is over, this money starts to look for a hot time in some other market.
Think the decline of the yen—and hence the rise in Japanese stocks—might be coming to an end in the next few days or weeks? Well then, how about the current China rally? Time for global money to slosh into Hong Kong and Shanghai?
Part of this rally is as short-term and speculative as the Japanese yen play—Chinese financial stocks, especially securities brokerage stocks such as Citic Securities (6030.HK in Hong Kong), have soared on bets that the Beijing government was not only interested in stimulating the economy but also moving to intervene to prop up stock prices. Shares of Citic Securities were up 35.3% from December 3 through January 16.
But part is based on actual fundamental trends. In response to a wave of stimulus—increased spending (again) on infrastructure projects such as rail, subway, and airport projects—economists now expect that China’s economy grew at a 7.8% rate in the fourth quarter of 2012 from the fourth quarter of 2011. That would be a significant pickup from the 7.4% growth in the third quarter because it would mark the growth rate in that quarter as the bottom of this economic cycle for China. Economists also expect to see factory output climb at a 10.2% annual rate in December and for retail sales to move up at a 15.1% annual rate. Both figures would be a slight uptick from growth in November.
So a rally in China would likely have more staying power than a rally in Japan because the underlying fundamental trends are stronger for China. At a basic level, China’s economy is growing whereas Japan’s isn’t. (And the hope that Abe’s stimulus plan will actually produce much growth is exactly that, a hope.) I think investors can expect to see China’s current rally go from one led by speculative financial stocks and commodity producers to one that includes domestic growth companies such as Home Inns & Hotels Management (HMIN), a member of my Jubak’s Picks portfolio http://jubakpicks.com/ and Tencent Holdings (TCEHY in New York and 700.HK in Hong Kong.)
The Shanghai Composite Index is up “only” 16.7% from December 3 to January 16. Considering past history, where a rally in Shanghai can total 30% to 40%, and considering that Shanghai stocks began December 3 near a four-year low that’s not a huge move.
On the other hand, there are enough lingering doubts about China’s ability to pull another growth rabbit out of its hat to put a limit to the rally. There’s an undercurrent of worry about China’s banking system, about the debt load at China’s local governments, about China’s slipping competitiveness as wages rise to make investors cautious as valuations rise. Nobody is, after all, looking for a return to the days of 9% or 10% growth in China. Economic growth next year is pegged at 8.4%. And at some point at 8.4% growth traders and investors will start to fret about valuations in China’s stock markets and the limits to China’s growth rate for this cycle.
Then the global hot money will start to move on.
To me, then, 2013 looks like a year when emerging markets will outperform developed markets, but in which no one emerging market story has immense staying power. China will yield its crown as the hot market of the moment to some other market after, say six months. That won’t mean that China’s stocks will collapse, only that they go from being the flavor of the moment to a more staid but still nourishing meal.
How will the global pattern roll out in 2013? It’s hard to tell this far in advance. India could succeed China, but the country has the potential for government policies that shoot the economy in the foot. Brazil will see its moment in the sun thanks to upcoming soccer world cup in 2014 and the Olympics in 2016, but the Brazilian consumer is carrying a worryingly heavy debt load. Mexico strikes me as a good second half play if growth picks up even modestly in the United States, the country’s biggest market. Turkey is an interesting second half play too—if wars wind down in Syria, conflict stabilizes in Iraq, no war breaks out in Iran, and the EuroZone shows any sign of coming off the floor. In that scenario an exporter like appliance maker Arcelik (ARCLK.TI in Istanbul) would do well. (Not that the stock, up 84.8% in the last 12-months has been a laggard.)
Of course, you shouldn’t think just in terms of which national markets will move ahead most strongly in 2013 (and when), but also of those companies that look best positioned to take advantage of a year that favors emerging markets. For example, Brazil’s Natura Cosmeticos (NATU3.BZ in Sao Paulo) recently bought 65% of Australia’s Aesop in a move to break out of its Latin American stronghold and build a presence in markets such as Australia, Japan, and the United States. Chile’s CorpBanca (BCA) has used the turmoil of the euro debt crisis to buy stakes outside its home market from Banco Santander (SAN.) Mexico’s Grupo Televisa (TV) is expanding into the United States with the country’s increasing Spanish-speaking population.
If you can figure out which emerging markets are about to get hot before all the heat turns to ashes, more power to you. There’s nothing wrong with being a momentum player in emerging markets as long as you realize you have to move early to avoid buying high and selling low. The time, I’d say, to increase your weighting in China is now—not in three or six months when the trends are clearer but the prices are higher.
But you don’t have to play a game of musical chairs either. You can instead concentrate on the shares of the best companies that are growing from being dominant players in their local markets to being regional or global brands. That’s a way to play a steady long-term trend, that of the relative rise of the world’s developing economies. Much of the next generation of global brands, the next Coca Colas (KO) and McDonald’s (MCD), will be from the world’s developing economies. Picking up a few of these during the volatility that I think is likely to characterize 2013 is a way to profit from that volatility without getting completely caught up in the short-term.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Arcelik, CorpBanca, Grupo Televisa, Home Inns & Hotels Management, Natura Cosmeticos, and Tencent Holdings as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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