Coz that's where the Money is!

When legendary robber Willie Sutton was asked why he only robbed banks, his answer was rather simple: “Because that’s where the money is”. Investors follow a similar logic on the financial marketplace. They flock towards assets with the strongest growth characteristics, particularly during the later stages of a bull market when growth is in short supply.

Emerging markets have turned out to be the biggest beneficiaries of the Federal Reserve’s rate cut two weeks ago even though the primary objective of the US central bank’s action was to stabilize the US financial markets and limit the negative macroeconomic follow-through from the credit crunch. Within the emerging market complex too, markets with faster growing economies such as China and India recorded outsized gains despite the higher valuations already assigned to stocks in those countries.

This behavioral pattern is consistent with past cycles when any increase in global liquidity following a crisis headed more towards asset classes exhibiting relative strength rather than in the direction of weak performers. After all, most developing countries did not need any monetary help as their economies continue to grow at a rapid clip even in the face of a US slowdown. It is precisely such solid growth credentials that make emerging markets even more appealing for global investors who know it’s difficult to reinvigorate a weak asset class at this late a stage of the economic cycle.

The global economy has followed a remarkably uniform path over the past fifty years. Typically, a new economic cycle gets underway at the start of each decade and the rising growth tide initially lifts all the boats. Midway through the decade, central banks begin tightening monetary policy in order to pre-empt any inflation breakout. Higher interest rates always lead to financial turmoil in some part of the system.

Central banks then begin to adopt an easing bias, as the priority shifts to avoiding a wider crisis especially when inflation is usually not a major issue as yet. This sets the stage for a bubble in the few asset classes unaffected by the crisis as they were never in need of extra liquidity. By the end of the decade, the whole cycle begins to unwind with inflation ending being a more general problem as productivity gains diminish, leading to more concerted central bank action.

Japan in the 1980s and the US in the 1990s were winners of the late cycle boom. The scene is being set for emerging markets to be the mania of this decade. For the first time since the mid-1990s, emerging markets are now trading at the same valuation as developed markets. The price-to-earnings, or P/E, ratio based on one-year forward earnings is currently at 14 for both the asset classes. What most analysts tend to forget is that before the series of crises broke out in emerging markets in the mid-’90s, starting with the Mexican peso devaluation in December 1994, emerging markets used to trade at a premium to developed markets.

At the peak of their relative performance versus developed markets in September 1994, emerging markets were trading at a P/E multiple of 22— a 25% premium. The thinking back then was that emerging markets deserved to trade at a higher valuation given their stronger growth attributes. However, the disappointing earnings growth profile of companies in developing countries — due to their lack of focus on profitability and poor corporate governance — led to a substantial de-rating. Money fled to the US in a massive way later that decade with earnings growth exploding of US companies on the back of a tech-driven boom.

It’s remarkable that despite a more than a four-fold jump in emerging market indices over the past five years it is only now that emerging markets are trading at parity with developed markets in valuation terms. Earnings growth has been the main driver of returns for emerging markets but now it seems investors are once again gaining the confidence to pay a higher multiple for the asset class.

By the time this cycle ends, it’s likely that emerging markets will trade at a considerable premium. The power of P/E expansion is illustrated by the fact that if emerging markets get back to their 1994 P/E ratio of 22 it would translate into another 60% gain for the asset class. In addition, there will obviously be some earnings growth and even currency appreciation for the dollar investor.

P/E expansion is one of the most difficult concepts for financial analysts to comprehend. Many intangible factors drive this ratio, ranging from long-term growth and inflation expectations to just market sentiment. What history suggests is that as the breadth of a global economic expansion begins to narrow during the second half of a decade, investors tend to concentrate their bets in the few remaining growth areas.

Little wonder, capital flows to emerging markets have begun to accelerate following the credit crisis in the US. The challenge will be when inflation begins to rear its ugly head in the US or China — the main suppliers of global liquidity. It is important to understand that the Fed is currently able to respond to the credit crunch and cut interest rates because inflation is well behaved. In China, meanwhile, inflation is turning out to be a bit of a problem. However, the Chinese authorities have so far only taken incremental steps to tighten policy as they view food price inflation to be a non-monetary phenomenon and inflation minus food is rather tame.

Emerging markets are currently enjoying the best of both worlds: growth dynamics remain strong led by China while liquidity is abundant as the Fed reacts to weak US growth. To prevent a bubble, central banks in emerging markets will need to de-link their monetary policy from the US. But with inflation not yet a major concern in many developing economies and China reluctant to let its currency appreciate in a meaningful way, central banks are in no hurry to engage in any major regime shift. It’s no surprise then that global investors are piling into emerging markets, as that’s where the money is.