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| From the Editor |
Crash Course
Dwight Cass
08/01/06
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Journalists who predict market downturns can take some comfort from the fact
that they will, eventually, be proven correct. However, those lone
wolves who
start too soon, like those who began heralding the dot-com
crash in 1996, are
not remembered fondly by their readers, at least
those who heeded their warnings
and stayed on the market
sidelines.
The outpouring over the performance of
the markets,
and especially emerging markets, from the financial commentariat
over
the last two months has had a distinctly March 2000 feel about it. But the
issues facing investors right now are significantly more complex than
those that
inflated and popped the Internet bubble.
 The sudden
drop in appetite for
risky assets precipitated by the
higher-than-expected April inflation figures,
combined with concerns over the alleged inflation dovishness of Fed
Chairman Ben
Bernanke—and a series of otherwise hawkish remarks by a
number of his Fed
colleagues—tripped emerging and developed markets
alike in May and June. As
investors began to recognize that interest
rates would continue to rise—not only
in the eurozone and Japan, but
here also—they suddenly realized it might make
sense to shift from
increasingly expensive risky assets to those lower-risk,
cash-like
instruments whose returns were inching upward.
It didn’t help
that, within a two-week period, the European Central Bank issued a
report
likening the risks posed by hedge funds to that of a bird flu
pandemic, the
president of the New York Fed said banks were not
exercising enough caution in
their lending to hedge funds, and the
World Bank said a number of developing
economies were at risk from
investors’ sudden flight to quality. Inflation, rate
hikes and this
litany of woe—no wonder markets around the world plunged.
The
stock
market’s skittishness and stumbles captured most of the headlines.
However, valuations in the domestic equity markets remain reasonable
and
corporate profits still relatively strong. It is the formerly
high-flying
emerging and commodity markets that are the real worries.
Indeed, it looked for
much of May and June as if the four-year emerging
markets bonanza had run its
course.
But there is an important
difference between a return to fundamentals
and an outright crash. With
the private investor community exposed to emerging
economies through
hedge funds, private equity and direct investments (not to
mention
their increasingly important role as funders of U.S. profligacy) the
health of these markets is crucial to our own
well-being.
Fortunately, not
all the news is dire. Much of the
capital that has flowed in recent years to
emerging markets has been
direct, rather than portfolio, investment. This is
stickier than the
sort of hot-money flows that washed in and out of these
countries in
the Tequila, Asian, Brazilian and Russian crises of the 1990s.
A
fair amount of that direct investment is coming from other emerging
markets,
such as China, which are running account surpluses. These
countries are eager to
invest that capital in ways that accelerate
their own economic development. They
are making long-term investments
that support asset prices and growth in other
emerging economies, all
of which indirectly benefits portfolio investors. There
is also a
geopolitical benefit—if, for example, China and India invest in one
another’s markets, it raises the cost of conflict between two
traditional
enemies.
Understanding the type of markets that can
be profoundly shaken by
something as off-the-radar as a fiscal crisis
in Iceland (which caused a severe
hedge fund shake-out in March, with
widespread repercussions for other emerging
markets) is no easy matter.
The fundamental premise of doomsayers, that rising
interest rates in
the U.S., Europe and Japan will mop up a lot of the excess
liquidity
that has driven technical gains in markets around the world, is
correct; the extent to which this will reverse those gains, rather than
simply
moderating them, is anyone’s guess. While simply investing in a
broad portfolio
of emerging-markets assets is probably no longer the
easy ticket to double-digit
returns that it was two or three years ago,
there will still be enormous
opportunities in individual markets—for
those smart enough to find them.
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