Sunday, August 12, 2007

EM as panecia for global markets - the clock is ticking

Although the US is the center of recent financial market turbulence and potential economic distress, data points continue to accumulate which indicate that developing markets, far from being the answer for whatever may ail global markets, will - along with the US - be key factors contributing to the next economic and financial market downturn.

Led by Goldman but now more or less consensus is the received wisdom that:

  • EMs are far stronger and sounder "this time"
  • EMs will continue to grow at a rapid pace with less variability, and hence will power global growth
  • EMs have unlimited human resources and hence will restrain global inflation - as they have in the past - for many years to come
  • EM = new economic paradigm (I always wanted to use that word but never before had the opportunity. thanks EM).

For example, those who argue that US commercial RE, though expensive compared to historical valuation metrics, is fairly valued because there has been a secular decline in global economic volatility and inflation. This, it is argued, means one ought to pay higher prices for all financial assets.

But what if developing markets turn out to be a lot like every other economy in human history? What if their economic growth (though more rapid on average) is cyclical? What if the human resources in certain EMs (China, India) , instead of being unlimited, are finite and substantially less abundant than estimated by consensus? Hence, rapid growth results in full utilization of labor (as well as physical supply factors) causing inflation. What if multi-year commodity booms caused much of the growth in certain EMs (Brazil, Russia) over multi-year periods and masked the lack of fundamental economic and financial market reforms?

It is my view that anyone who thinks that the qualities of developing market economic growth and inflation are such that one ought to be fundamentally bullish on global asset prices... has a BRIC for a brain. And if you didn't see this a year or two ago, you should certainly see it today. Resource constraints are fueling inflation in India. Average wages are growing at 15-20% in China. Inflation in Russia is 9%, Hungary 9%, South Africa 7%, Argentina 9%. Global investors are bullish because "we all know" that EM currencies will significantly appreciate over the next few decades. But appreciation of the Rupee and Renminbi = depreciation of the dollar which will put upward pressure on prices in the US. Last Friday import prices on products from China were reported as rising for each of the last two months. This week's Economist provides the latest grist for my, "EMs may be hazardous for the health of global asset prices" view: EM money growth (real) has been steadily accelerating and is now growing at 16% per year. Developed market central banks - those smart fellows who were never going to allow inflation to get out of control again - "no longer determine global monetary conditions".

And you thought all you had to worry about was tighter global credit and a housing bust...

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