Daniel Altman

Myopia in the Markets

Myopia in the Markets

It’s a tough time to be investing in emerging markets. Index funds tracking their shares dropped about 10 percent in December and January, and several of their currencies are hitting the skids as well. Five mid-sized markets are in turmoil, and the signs are not good in at least two of the biggest ones. Meanwhile, the traditional economic powers are still having trouble emerging from their own slumps. But there are better times ahead, perhaps sooner than investors might think.

For the mid-sized markets, the troubles are largely of their own making, at least in terms of recent history. Egypt, Thailand, Turkey, and Ukraine are going through political crises that have polarized their populations and stoked fears — at least among pundits — of civil war. Argentina, like a patient with malaria, is suffering yet another of its periodic bouts of inflation and devaluation.

Together, these countries will likely account for more $2.2 trillion in output this year. That’s about 2.9 percent of the global economy, but also about 7.5 percent of emerging markets’ gross domestic product. Either way, it’s enough to get investors’ attention, and the declining value of their assets in these countries may cause them to shift their portfolios away from other developing countries as well. As some risky markets become more uncertain, the response is often to pull back from other risky markets as well.

Throw in the Federal Reserve’s tapering of its cash injections into security markets, and things start to look very hairy indeed. Investors had been borrowing cheaply in the United States and plowing the money into high-return assets in emerging markets. But with interest rates rising, their ability to carry dollar-denominated debt is tapering as well. The deluge of investment into emerging markets is starting to ebb, and even to reverse itself, just when it is needed most.

As though all this weren’t enough, China may be about to hit a huge speed bump. With economic growth already lagging behind expectations — just compare the International Monetary Fund’s forecast from October 2010 to the one from October 2013 — China’s shadow banking industry may be as challenging to unravel as were the bad loans in its state banks a decade ago. This matters, because China is much more than a supplier of cheap manufactured goods to the United States and Europe. It also buys billions of dollars in products and services from emerging markets, as well as sending them raw materials, intermediate goods, and money for aid and direct investment. When China gets a cold, the rest of the developing world comes down with avian flu.

Then there’s Brazil. Preparations for the World Cup have hardly gone smoothly, with charges of corruption and cost overruns regularly making the news. Economic growth is expected to slow this year from a rate already far below the norm for a major emerging market. In addition, anything less than a victory in the finals of the tournament could create further discontent or depression in the soccer-obsessed nation.

Barring recessions in the United States and the European Union, things couldn’t get much worse for emerging markets from the global macroeconomic perspective. But there are plenty of reasons to think they’ll get better soon.

First, the program of economic reform set out by Xi Jinping’s government in Beijing could lead to a new wave of investment and growth in the China. There will undoubtedly be some growing pains as capital markets are liberalized and the state’s role in the economy is reduced; this process could and probably should take several years. But a streamlined and more competitive Chinese economy will be strong engine for growth around the world.

Next, the United States will soon enter what has traditionally been its most fertile economic period: the years before a presidential election. Since 1930 (the earliest year for which the Bureau of Economic Analysis provides data), the annual rate of economic growth in the two years before a presidential election has been one percentage point higher, on average, than in the two years after. More growth in the United States will mean more demand for imports from across the globe.

Europe and Japan may finally be ready to do their part, too. For the first time in three years, the European Union is on track for what qualifies as steady growth over there. If the European Central Bank finally loosens monetary policy after continually missing its inflation target, growth might even reach 2 percent after this year — good news for imports from emerging markets. In Japan, it looks like Abenomics may be spurring demand for imports as well, belying worries about a falling yen.

Conditions may also improve within the emerging markets themselves. Argentina has presidential elections coming up in 2015; saner economic policies could come even sooner if the current government fails in its bid to rescue the peso. Turkey may find itself in a position similar to that of Brazil in 2005, when a corruption scandal failed to unseat the government in part because the economy was thriving. Thailand and Ukraine are edging closer to conflict, but Thailand, at least, has a history of keeping such episodes brief and relatively bloodless.

Could investors or their governments do anything to help resolve these crises? Don’t bet on it. Most of them will simply watch and move their money elsewhere when things get too hot. Unfortunately, that withdrawal of capital will just make matters worse, potentially adding economic instability to political problems.

This is the situation that countries accept when they enter global financial markets: economic and political cycles that magnify each other. Yet it might not be so harsh if today’s investors, so obsessed with short-term profits, took more of a long view. Within a couple of years, those who pull their funds out now may live to regret the decision.