By Gary Shilling
24.05.2006
SourceEmerging stock markets did very well last year, with Morgan Stanley’s index gaining 30% as foreign investors piled in. Many of those economies were robust.
Conditions there were very reminiscent of the 1990s when the emerging economies of East Asia - including Thailand, Taiwan, South Korea, Indonesia, Malaysia, Singapore, the Philippines and Hong Kong - were the portrait of stunning economic growth. The region thrived by providing the West with cheap electronic components and other exports. As international capital markets opened up, foreign investors began pouring money into the East Asian countries to profit from the region’s growth. As subsequent events proved, however, much of that money was ill-spent.
The problems became clear with the currency crisis that began in Thailand in July 1997, when that country devalued its baht currency, and investors responded by pulling money out in a virtual stampede as the currency nosedived.
Beyond Thailand, South Korea and Malaysia also experienced rapid money depreciation as currencies fell in domino fashion. The withdrawal of capital led to significant retrenchments in other areas of those economies. Growth rates fell through the floor in 1998, especially in Indonesia, Thailand, Korea and Malaysia. The region’s stock indices plummeted.
Within a few short months, the emerging economies of East Asia, once heralded as shining examples of export-driven growth, offered newer lessons on the shortcomings of their development. Topping the list were cronyism, lack of transparency, undeveloped capital markets, inadequate banking regulation and plain old-fashioned graft and corruption.
The industrious Asians, however, did not remain depressed for long. Sure, nepotism and other unsound business practices, at least by Western standards, were eliminated more on paper than in fact, but economic growth revived and the region was depressed only to a limited extent by the US dot-com collapse and 2001 recession.
The Asian Tigers: has domestic demand replaced export dependence?
Inflation has remained low, despite recent leaps in energy prices, in Hong Kong, Taiwan, South Korea, Malaysia and especially Singapore - while the Philippines, Thailand and notably, Indonesia have had meaningful inflation. Interestingly, these three countries have also suffered from political unrest in recent years. Not surprisingly, central-bank interest rates remain low in the low-inflation lands, but higher in the inflation-prone Philippines, Thailand and Indonesia.
These export-driven countries have also been aided by the collapse in their currencies in 1997-1998. Some of their currencies have subsequently gained against the dollar, but remain well below their pre-crash levels. Direct foreign investment has been returning to those lands, although collectively well below China’s, as nonperforming loans drop.
In the aftermath of the 1997-1998 collapses, a number of the Asian Tigers realized that part of their vulnerability lay in excessive dependence on exports for economic growth. Two of these countries - South Korea and Thailand - tried, without much success, to promote domestic growth to reduce that dependence.
I have long felt that probably the most important result of the Industrial Revolution was the development of the vast middle classes in Western economies. Before that, the agricultural societies concentrated wealth and income at the top of the economic spectrum. With the Industrial Revolution, the middle class grew huge, had significant income, and spent it on their kids’ education, the good life, etc. That created enough domestic demand to spawn largely self-sufficient economies.
I’ve argued, contrary to the views of many, that developing countries, including China, have not yet gained big enough middle classes to spawn domestically driven - as opposed to export-driven - economies.
Despite all the cell phones and computers purchased by the Chinese of late, I believe those folks are simply spending the money coming from exports and direct foreign investment. With the next global recession, probably initiated by a US house price collapse and fall in American consumer spending and imports, we’ll see who is right on the Chinese domestic-led growth argument.
In any event, the Asian Tigers remain dependent on exports, most of which, directly or indirectly, are bought by US consumers who have been the world’s growth engine in recent years. American incomes have been insufficient to finance consumers’ robust spending, so they’ve relied on the equity in their houses to support higher borrowing and lower saving.
The Asian Tigers: stocks are too expensive
The combination of some financial and business reform among the Asian Tigers and more importantly, robust export-led economic growth, attracted foreign investment that hyped their equity markets, last year. That promoted more interest this year, when $20 billion flowed into emerging-market stock mutual funds in the first quarter. This is the same amount as entered in all of 2005 and many of those stock markets continue to do well.
US institutional investors, such as pension and endowment funds, are also pouring money into emerging market hedge funds to the tune of $5.3 billion, last year. This is up 13% from 2004, and about $2 billion in the first quarter of this year. This money is in addition to institutional ownership of emerging-market stocks directly and through mutual funds.
As a result of all this foreign buying, Asian Tiger stocks are no longer cheap, given the historical volatility of those emerging markets. The export-led Asian Tiger economies will be especially vulnerable if the current softness in US housing activity turns into a full-blown collapse. Then American consumers will have no other means of supporting their spending and will retrench to the considerable detriment of Tiger exports.
Furthermore, a strong dollar - which I forecast, on balance, for this year - can slash gains in foreign investments for Americans. Last year, the Morgan Stanley Capital International EAFE Index, a broad measure of stocks in Europe, Australia and developed Asia, rose 26% in local currency terms, but only 11% after accounting for the strong dollar.
Then there’s the threat of protectionism. Congressional ire is now focused on China, but history shows that any export-driven country is fair game when a weak US economy spikes unemployment at home. Furthermore, rising global interest rates, as at present, have historically been punishing for stocks, especially in volatile emerging markets. Also, remember that small-country markets leap when foreign money floods in, but collapse even faster when it departs.
The Asian Tigers: 1997 revisited?
Why won’t we see a repeat of the 1997-1998 debacle among the Asia Tigers? They’re more export-dependent now than in 1996. Short-attention-span hedge funds are now involved in their markets. And, if things start to somehow unravel, foreign investors will recall their big 1997-1998 losses and want to beat the crowd out the door.
There is also the matter of correlation among stock markets. For years, I’ve analyzed the close correlations among stock markets around the world, most of which usually follow the US. These relationships are far from perfect. Last year, while foreign stocks rose 26%, the S&P 500 index of American equities advanced only 3%.
Still, the evidence is that markets are moving more in sync now than earlier, not surprising in an increasingly interconnected global economy. It’s also true that the correlations of the S&P 500 index and its components have increased dramatically since the dot-com days of 2000 and even hedge fund returns now are closely linked to S&P performance.
From 1990 through March of this year, the correlations between Far East emerging markets, the total emerging market sector and emerging markets ex Asia, on the one hand; and those in developed Asian countries, the United States, and Europe on the other, were quite low, but the correlations have been much higher since 2004.
Two factors are probably responsible for the higher interrelationships more recently. First, economies, and therefore stocks, are increasingly interrelated. Second, and probably more important, the Asian meltdown in 1997-1998 was a regional, not a global affair. The collapse in stocks in the Asian Tigers then did not spread worldwide.
This suggests that troubles in the US economy and stocks cannot be sidestepped by emerging stock markets in Asia and elsewhere. At the same time, however, the history of the late 1990s indicates that troubles for the Asian Tigers don’t necessarily spread globally.
It’s possible, then, that the Asian Tigers could once again go their own way, but I suspect that their fates lie in the hands of US consumers, who buy the exports that propel their economies. So, the softness in American consumer spending I expect to accompany a big house price drop, will weaken both the United States and Asian Tiger economies. In turn, that will logically sire synchronized declines in stock markets on both sides of the Pacific.
By Gary Shilling for The Daily Reckoning.