One of the kids in Broadway's "The History Boys" dismisses history as "one *$^!% thing after another." That's certainly how it has played out in emerging markets.
Runaway inflation in Latin America; Russia reneging on another deal; Asian currencies in a twist; the latest Middle East crisis. And this month, air coming out of the bubble in commodities, which is the one asset most developing markets have in common.
After trebling in three years, prices of emerging-market stocks were due for a correction, and it was a doozie: A plunge of more than 16% in iShares MSCI Emerging Markets Index (EEM, news, msgs) between May 9 and May 24.
"The fever has broken in the commodity markets, in emerging stock markets and in currencies," says Ed Yardeni, chief investment strategist at Oak Associates. "This is a good thing. Risk aversion is back."
Bringing money back home
This is a good thing for U.S. markets, Yardeni argues, since they're less risky than developing bourses and will benefit as investors switch from there to here. But it's ominous for those risky emerging markets. They are very likely to fall further –- on average, 8.5% over the next 12 months, based on past emerging-market meltdowns.Investors are already fleeing the group en masse. Inflows to emerging-markets mutual funds "have definitely dropped off, from $1.6 billion a week average in the year-to-date to just peanuts -- maybe $40 million," in the week ended May 17, says Brad Durham, managing director of EmergingPortfolio.com Fund Research. He estimates they turned into outflows after that.
I'm with those folks: The odds say now's a good time to take profits in this group. Don't even think about buying into it.
That sucking sound? Inflation
Commodities have taken a pummeling ultimately because the exuberant, demand-generating global economy is going to become less exuberant, which is demand-destroying.Inflation is running ahead of the average it set over the last decade, and not just in the United States. To fight it, central banks have indicated they will continue raising interest rates (in the U.S.) or begin to (in Europe and Japan). Higher rates put a brake on business growth by pushing up costs.
Until now, Japan's near-zero interest rates have made possible the famous "carry trade," in which investors such as hedge funds borrow for practically nothing and use the money to invest in high-return assets like emerging markets. Higher rates put an end to that, and just the threat of them has throttled that market.
As to risk: Risk is why emerging markets never emerge. Their politics are quicksand. "Leftist Lula wins Brazil election," the BBC reported in October 2002. "Left-wing protestors demand Lula resign," it reported three years later.
Modern emerging-markets tempests were kicked off by the massacre in Tiananmen Square, which sent the emerging-markets index down 12.4% in June of 1989. Investors quickly shrugged it off, however, and in the succeeding 12 months the group zipped ahead 22.6%.
Since then, the benchmark has declined 10% or more in one month 13 times, and rebounds have become rarer and even deceptive.
| Month of 10% decline | Next 3 months gain or loss | Next 12 months gain or loss |
|---|---|---|
June 1989 | 21.47% | 22.56% |
March 1990 | 19.29 | 27.1 |
August 1990 | -19.46 | 24.86 |
September 1990 | -4.15 | -2.53 |
June 1992 | -3.61 | 23.48 |
January 1995 | 2.05 | -19.89 |
August 1997 | -17.59 | 2.52 |
October 1997 | -9.55 | -10.28 |
May 1998 | -35.14 | -29.79 |
June 1998 | -23.03 | -40.43 |
August 1998 | 26.67 | -50.92 |
March 2001 | 2.88 | -37.27 |
September 2001 | 26.26 | -34.87 |
September 2002 | 9.76 | 5.85 |
Average | -0.3 | -8.54 |
Note: Percentages reflect gain or loss in the MSCI Emerging Markets Index, determined using dollar values rather than international currencies. Source: Morningstar Inc.
Reading history
The mother of all meltdowns followed Russia's default on its bonds in the summer of 1998. Developing markets had already been savaged that year by the collapse of the Russian stock market and the "Asian contagion," a cascading series of currency declines.In the default itself, political gadfly George Soros lost $2 billion and Long Term Capital Management, the Titanic of hedge funds -- a $6 billion portfolio whose strategy was supposedly foolproof -- had to be bailed out by the U.S. government.
Total losses to hedge funds and other Western investors were pegged at $70 billion. After falling a record 29.2% in August, the MSCI emerging-markets benchmark made nearly all of it back in the succeeding three months, but it was a dead-cat bounce. In the 12 months ended August 1999, the index plunged 50.9%, its worst 12-month rout ever.
On average, emerging-markets equities give up 8.5% of their value in the 12 months after a sharp correction.
So is this party over? Guided by the odds and history, I'm unwilling to bet any other way.
If you have owned emerging-markets funds for any significant period, you have plenty of profits to harvest by selling. Prices are still up 160% from where they were three years ago. If you don't own them, now is no time to shop: There are no bargains to hunt.
When I last rebalanced my portfolio of exchange-traded funds in March, I put stop-loss orders 15% below share prices at that time. iShares MSCI Emerging Markets Index went up about 15% subsequently, so even after its steep decline, it is only a few percentage points below where it began.
I've not been stopped out of that position, but I expect to close it out when I next rebalance, one month from now. I can earn more than 5% on Treasury bills with zero risk. Yardeni certainly has my number: Risk aversion is back.
Meet Timothy Middleton at the Money Show
MSN Money mutual funds columnist Timothy Middleton will appear along with many other top investment professionals at the Money Show in Washington, D.C., July 20-22. Tim will hold a seminar on "Seven ways to boost investment income," and speak at an in-depth intensive seminar titled "Exchange-traded funds -- the future of diversification." Admission to the show is FREE for MSN Money users; there's a separate fee for the ETF seminar. For complete details or to register for free admission, call 800/970-4355 (be sure to mention priority code #006137), or click here to register online.At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
