Which Way(s) Will World Markets Go?

07/02/2010 8:23 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

They probably won't move in step over the next few months. Emerging economies may be on the upswing, while developed nations may not be so lucky. What's an investor to do?

It may not look like it, but the world's stock markets are about to start moving in different directions.

That's certainly not at all clear now. Most days recently, all the world's stock markets have moved in the same direction: Down. On June 29, for example, the US Standard & Poor's 500 Index dropped 3.1%, Germany's DAX Index fell 3.3%, and China's Shanghai Composite Index plunged 4.3%.

But I think sometime in the not-too-distant future—the next three to six months would be my best guess—the stock markets of the developed and developing worlds will start to diverge. Six months from now—or less—stocks in China, Brazil, India, and many other developing markets will be in clear uptrends, and stocks in the developed economies of Europe and Japan will still be stuck in decline. The United States will be left in the middle, straddling the divide between the two groups.

Why?

Because the underlying economies are headed in radically different directions within that time period. And where the economic fundamentals go, stocks eventually follow.

If I'm right, this divergence should be the cornerstone of your investment strategy over the next year or longer. And, if I'm right, how you allocate your portfolio between these two diverging blocks of economies and markets will determine how well your investments perform during that period.

Let me lay out the case for this divergence in the economic fundamentals and stock markets. And then you can judge for yourself if I'm right or not.

The Problem with Fixing the Problem

The recent G20 meeting of the world's largest economies marks a good starting point for looking at the economies of the developed world.

And when we look, what do we see?

Annual government budgets that are deeply in the red. The US budget deficit is forecast at 10.6% of GDP in 2010. The United Kingdom’s is forecast at 10.1%. Spain’s is forecast at 9.1%; France’s, 8%; Japan’s, 6.4%; Germany’s, 5.5%.

How bad are those numbers? Economists estimate that a budget deficit of 3% of GDP is sustainable. Above that, a country is piling up debt that it can't repay under reasonable assumptions of growth (and manageable inflation). In the long run, that leads to falling growth rates, climbing interest rates, and finally, fiscal crisis.

That's why the final communiqué from the G20 made such a big deal of two deadlines. First, leaders of the G20 agreed that they would aim to cut their annual deficits in half by 2013, and second, aim to stabilize or reduce the total government debt-to-GDP ratio by 2016. That's tantamount to a call to reduce annual budget deficits to 3% of GDP or less.

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The leaders of the G20 were careful not to call any of this an actual agreement or even a promise. These were goals, aims, expectations. (For more on exactly what the G20 meeting did or didn't achieve, see this post on my Web site.)

But still, as loose as the timing in these aims is, as vague as these promises turn out to be, as good as the odds are that no country in the group will actually achieve these goals, the agreement does indeed describe a broad economic trajectory that goes like this: High-deficit developed countries will cut government spending over and over again during the next five years or so. The cuts aren't likely to be serious enough to end the debt crisis in these economies, so the total package over time will include less government spending, higher taxes, slower economic growth, and rising interest rates.

As a fuel for stocks, that's got about as much bang as a wet squib a week after the Fourth of July. But that's the course that countries such as France, Spain, the United Kingdom, and maybe even Germany have chosen.

Contrast that with the path that the world's big developing economies are headed down in the years from now to 2013 or 2016, the years in the G20 press release.

Brazil, India, China, and other developing nations don't have huge debt from the financial crisis and subsequent stimulus spending to pay off. For example, Brazil's government deficit is currently running at about 3.24% of GDP. The International Monetary Fund estimates that the ratio of government debt to GDP in developed economies will rise to 110% by 2015 from 91% at the end of 2009. In comparison, in April 2010, Brazil's government debt amounted to just 42% of GDP and is headed down to 30% of GDP by 2014, the Brazilian government estimates.

That's not just the stabilization that the G20 aimed for as a goal by 2016 in its recent press release—it's an actual decrease in the burden of government debt on the economy. And the decline in debt and the restrained spending pattern are among the reasons Brazil earned its first-ever investment-grade rating from Standard & Poor's this year.

Trouble of a Different Sort

That's not to say the world's developing economies don't have problems. China has an asset bubble in real estate, as well as a runaway money supply that threatens to send inflation soaring. Inflation in Brazil is running at better than 5.2%, way above the government's target of 4.5%. India is facing similar inflationary pressures.

And there's a very real possibility that measures to control inflation—interest-rate increases or increases in the bank reserve requirement—will overshoot and, combined with the slowdown in growth in the developed world, send economic growth rates in China, Brazil, and the rest of the export-oriented economies of the developing world lower than expected.

But look at the very different nature of the problems facing the developed and developing groups. It's too little growth and the possibility of even more slowing in the developed world versus too much growth and the possibility of a stumble in the developing world as governments there try to keep growth under control.

And look at the very different time frames for working out those problems.

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In the developed economies, we're looking at a very long, slow grind back to fiscal stability. Years. 2016. Even if politicians and voters decide to take the pain that doing what's necessary will entail.

And in the developed economies, we're looking at a very real possibility that in the time period I'm talking about—now through 2016—things will get worse before they get better. More unemployment. Slower growth. Goodies like that.

And that's not even considering the very real possibility that we'll all decide to shirk the hard work and opt for the easiest short-term solutions. That puts us in the developed world in a truly horrible position for facing the really big problems that will arrive by 2030, when an aging population catches up with all of the world's major economies (with the exception of Brazil and India, where demographics don't get nasty quite so quickly).

The developing economies, on the other hand, are looking at relatively short-term risks of lower-than-projected growth, the bursting of an asset bubble or two, and higher interest rates. But in all likelihood, the worst of that will be over by the beginning of 2011.

Brazil, for example, looks like it will stop raising interest rates in 2010. India, too. China is well on the road to refinancing its banking system (using techniques for burying bad debt developed in the late 1990s to fix the excesses of the Asian currency crisis), if not this year, then next. And that will put worries about a real estate bubble to rest. (For more on why China might really be broke—if the accounting were honest—and how China plans to bury the problem, see "China's Ponzi-Like Banking Policy.")

In other words, developing economies still face pain, but it's short-run pain. And it's likely to be over by the end of this year (or sooner in some cases).

A New World Order

So by the last quarter of 2010, the world will look like this, in my opinion:
· In the developing economies, promising signs that worries about slower-than-expected growth can be put to rest, an end to interest rate increases, and increasingly solid-looking government finances (at least relatively).

· In developed economies, worries that growth is still very slow—so slow that a slide back into recession remains a possibility—and a background of budget cutting and rising deficits (as the budget cuts turn out to be less than advertised, as they always are).

The United States will fall somewhere in between the two groups, although much closer to the developed economy track. The Obama administration hasn't yet drunk the Kool-Aid of budget cuts, a la Germany and the United Kingdom, but Congress isn't likely to pass any more stimulus. And I doubt that the administration will be able to avoid major budget cuts, even if economic growth is anemic, after 2011. So the United States might grow with greater strength than the rest of the developed world in the near term, but eventually, it too will have to deal with its fiscal mess.

Now, like biology, macroeconomics isn't destiny. But I'd sure much rather have my money in stocks with the fundamentals of developing economies behind them than in stocks with the fundamentals of developed economies stacked against them.

See a hole in that argument? If not, you know where to put your money once the selloff in global stocks is complete and developed and developing stock markets start to diverge.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

See the complete Jubak Picks portfolio here

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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