The end is nigh for the Asian boom – but parts of Europe look perky
At the beginning of 2010 I was asked to announce my ‘trade of the decade’. Forecasting ten years ahead should be easier than forecasting short-term. But at the time the global economic outlook was more than usually uncertain. That made it tricky. So after a little thought I did what I normally do when stumped. I looked at what everyone else was predicting and went for the diametric opposite.
Fund managers and financial advisers were nuts for emerging markets in 2009 and 2010. I could barely see over my desk for research papers extrapolating 10 per cent GDP growth in China forever. At the same time most observers were down on western markets, despite them being much cheaper. So my trade of the decade was ‘sell the East, buy the West’ (with Japan being considered, perhaps perversely, part of the West).
So far this hasn’t worked out badly. Most markets, emerging and emerged, have seen double-digit gains in the last year: the Dow Jones rising 20 per cent; the FTSE100 up 16 per cent; Germany’s DAX 30 per cent; Hong Kong’s Hang Seng 15 per cent. Yet the two big eastern markets most people put their faith in haven’t done so well: India’s Sensex is up just 10 per cent and Shanghai’s CSI 300 has lost 2 per cent. And in the shorter term, things really have gone my way: the MSCI World gauge of advanced-nation equities has beaten that of emerging markets by five percentage points so far this year.
What makes me think this will continue? Several things. First, China. Yes, it’s been growing at 10 per cent a year for 30 years. But there is absolutely no reason to think that will continue. For starters, the government seems to have lost control of its credit bubble: bank lending is ten times the level it was in 2007 and the inflation genie is out of the bottle. Minimum wages in most cities are rising at double-digit rates. Official inflation is around 5 per cent but other statistics suggest that the real rate is either a lot higher already or about to go that way.
Optimists claim China can manage the situation — that the command nature of its financial system means it can orchestrate the monetary policy needed for a soft landing. But that’s not how this kind of thing usually ends. The City broker turned fund manager Terry Smith pointed out to me a comment made by a former Bank of China official in Davos last week. Yong Ding noted that China really needed to start tightening monetary policy — cutting rates, reining in bank lending — to prevent a ‘bubble in property and stock markets’. That would be reassuring if those bubbles didn’t already exist; and if it wasn’t exactly what the governor of the Bank of Japan was saying in 1989 just before the great Japanese bubble turned into one of history’s most spectacular crashes.
Markets hate inflation for several reasons. First, it eats away the profits of companies without real pricing power. Second, it tends to lead to tighter monetary policy, stopping firms from borrowing to expand. Third, it prompts policy error: interest rates rise too slowly and inflation goes out of control, or they rise too fast and you end up with deflation. And as much as markets hate inflation, they really, really hate deflation.
But inflation isn’t the only reason to think that emerging markets aren’t quite the place to be at the moment. The other is liquidity. One reason Asian markets have been bid up strongly is quantitative easing. This works in asset markets a bit like a hot potato. The US Federal Reserve creates new money to buy Treasury bonds. The seller uses the money to buy US equities. The seller of those uses the money to buy a fund invested in Taiwan. Round and round the money goes, and the result is a surge of cash pouring, on this occasion, into Asian assets.
But what if it turns out QE is actually working? It may not be doing much for US household spending, but as Henry Maxey of the Ruffer investment group notes, it might be doing something for corporate spending, ‘the key to any recovery’.
By taking deflation — the thing companies fear most — out of the equation, QE might be encouraging them to borrow and invest. That might be why some US measures of business expansion are running at their highest levels since 1988. Suppose this keeps going, and that everyone then sees prospects genuinely improving, the dollar stabilising and the threat of more QE disappearing. All that could pull liquidity out of emerging markets, bringing the boom there to an abrupt end.
Alongside the fact that things aren’t as bad as they might be in the US, it’s worth noting that even as eurozone politicians continue to bicker about their sovereign debt difficulties, confidence in parts of Europe is coming along nicely: German unemployment is at an 18-year low as exports boom on the back of a weak euro, and European retail sales rose at their fastest rate in four years in January.
None of this is to suggest that you will automatically make money investing in the West over the long term. You probably won’t. Why not? I refer you to two valuation measures that seek to tell us where markets will go over ten to 20 years, the cyclically adjusted price-earnings ratio and the Q ratio of market value to underlying asset value. According to their biggest fan, the strategist Andrew Smithers, they now tell us that the US market is around 70 per cent overvalued. That doesn’t mean it will collapse tomorrow but it does point towards muted expectations of future returns.
So if I had to choose where to place my bets, it wouldn’t be anywhere in Asia (Japan excepted). It might be France, the UK, the US or most likely Germany — which also has an increasingly rare factor in its favour: not being expensive. Despite its sharp rise since 2009, the DAX trades on an average p/e of around 11 times.
Dumping Asia for Germany and America is, for sure, not what most of your financial advisers are likely to be recommending. But the trade of the decade I declared a decade ago — buy gold, sell equities — didn’t do too badly. And I might be right again.
Merryn Somerset Webb is editor in chief of Moneyweek.