After recent lecture for ASBIRO University, many people started asking me about investing in stocks. Ultimately, it is the main group of assets for 90% of investors. In my opinion, the best question was about investing in emerging markets in the light of the huge wave of QE. It touched the official increase of money supply by central banks and also financial tricks enabling destruction of currencies through the Exchange Stabilization Fund.

Since the inception of the blog I emphasised that equities are very risky compared to their potential gains, with small exceptions. It has been confirmed outside of the US. Developed markets saw their equities moving horizontally. In emerging markets, we saw them seriously falling. The only place experiencing highs was the US. What is important is the fact that in the past we saw equities both in developed and emerging markets moving in the same direction but for 5 years now there is no such correlation.

 

Last 5 years of falling prices in emerging economies made those markets attractive. We see now Russia, Brazil, Turkey, Poland and China being relatively cheap.

Prices in many countries are much lower than in the UK or the US. Should those equities start surging now?

Absolutely not. Investors’ actions are irrational and searching for a particular pattern or key doesn’t make sense. Russia is cheap because it seems extremely unpredictable. Brazil is experiencing a serious recession. The proximity of the war in Syria puts negative pressure on prices in Turkey. Also, Turkey is yet to be retaliated upon by Russia (shooting down Russian aircraft a few months earlier) and investors already calculate this risk in. Without those risks, we would have seen prices at much higher levels.

Truth be told, it is hard to see any logic in capital movements. In 2013 stocks in China were cheap but investors only showed up in mid-2014 to quickly push prices up by 50%. Subsequent formation of a bubble and its burst happened due to ‘street money’ flooding in. Today prices are 42% below highs and slowly equities look more and more attractive.

Should I then allocate a share of my capital in emerging markets’ equities?

There is no simple answer to this but if you have to buy equities somewhere – choose emerging markets. This is why:

a) Price

When screening equities with P/E, CAPE, P/BV and others, we see emerging markets on lower (better) levels than the US, Australia or Western Europe.

b) Weakening USD

After first rate hike, in December, USD achieved its 13-year maximum and I believe it is going to weaken further. This is also proven historically. Before, USD recorded its maximums during rate hikes.

http://independenttrader.pl/fileman/Uploads/taniejacy_dolar.jpg

I do not expect another interest rate increase. A small ‘financial crash’ is playing into the FED’s hand because it gives big enough excuse to cut rates and officially start another round of QE.

When USD is getting cheaper we see higher prices of commodities and stocks in general in countries with commodity-based economies (Russia, Brazil).

c) Debt

Developed markets are already sated with its debt levels (consumer, corporate and public) - the economy’s growth is hindered with any additional credit.

The only choice is to reduce the debt. There are two ways of doing that:

- Debt write off and deflationary shock. Politicians and bankers hate it because it is hard to control the whole process;

- Printing and devaluation of the currency. It is always a preferred method because 95% of the population doesn’t understand it.

Consequences of debt reduction are more severe the higher the level of debt.

In developed world overall debt is around 280% of GDP. Emerging markets are under 170%.

http://independenttrader.pl/fileman/Uploads/global_debt_24_06_16.png

Source: estrategiastendencias.blogspot.com

We have to remember that today our financial markets are addicted to central bank’s QE like never before. Increasing the scale of printing boosts optimism levels among investors and makes them return to equities. With a visible difference in pricing between EM and DM, capital is more probable to move towards developing countries.

d) Equity cycles

During last 28 years and 4 full cycles (boom – slump), the capital moved to EM, then back to the US. Effectively prices were achieving levels of a speculative bubble only to stand still for another 10 years.

 

Source: Self-made

During the last cycle, a period of 8 years ending in December 2015, the US equity prices rose by 60% meanwhile EM lost 19%. Last time we saw similar situation 18 years ago after which EM equities gained over 400%. Will this time be the same? It is possible but the deciding factor here is another round of QE rather than fundamentals.

The US market is a trendsetter

Understanding how numerous factors are interdependent on each other is key to being a good investor. The New York exchange delivers nearly half of the capitalisation of financial markets in the world. It determines when other markets fall. When the US is growing, the rest of the world can move in various directions but when the US experiences significant decline it will affect everyone else. Capital is fleeing form stocks now and it is a global trend.

http://independenttrader.pl/fileman/Uploads/Por%C3%B3wnanie_24_06_16.jpg

Source: pensionpartners.com

During last 27 years, we can’t find a year when the US market falls and EM doesn’t follow. I don’t believe it is going to change now. In other words, when the US market is falling (and it has big potential to fall), this will make emerging markets cheaper.

Potential

When writing about emerging markets and their potential I must note that it is not one, monolithic market. On one hand, we have countries I mentioned before. On the other hand, we see very expensive Philippines, Indonesia or Mexico. Capital does not spread equally and the chart below is a clear example.

Since the beginning of the year, we see an average growth in EM at 5%. Meanwhile, Russia gained 18%, Brazil 34% but Chinese market lost 6%.

Summary

My approach towards equity markets doesn’t change. The biggest markets stand still for a year now. Since peaks of May 2015, we haven’t seen any movement. If we were to forecast the future based on historical examples we should have expected losses already due to expensive equities, the length of the boom, margin debt and many other factors.

Central banks around the world try to sustain the myth of economic growth with high equity prices – this is a very big problem. One after another, central banks using official ways or swaps, increase the money supply. The levels of interest rate are either close to zero or in the negative area. What makes it worse, central banks started to act like hedge funds and are purchasing equities and investing in real estate funds. In those circumstances their ability to affect the market is huge.

The market responded with fear and uncertainty to the result of Brexit referendum. The FED is known to use excuses and this one is perfect for them to start ‘saving’ the market with interest rate cut and another round of QE. Who is to blame? Brexit! It will be easy to buy time this way and by increasing inflation, they can reduce equity prices from a level of a speculative bubble to just ‘expensive’. More control and less risk of a financial crash.

Weakening USD and QE will most probably result in growth for cheap equities in EM. It would be a shame not to use such occasion. It is definitely not an opportunity for big profit unless you are experienced and temporary drops of 30% are not scaring you. The next decade will be the decade of EM and should give decent earnings. It doesn’t change the fact that people with weak nerves risk losing a lot of money.

 

Trader21