If Emerging Markets Stop Emerging

"The four most expensive words in the English language are, 'This time it's different.'"  
-- Sir John Templeton

It is earnings season once again and as the numbers come in I would expect that, whether good or bad, we should see the continuance of an ongoing theme as managers give their guidance.  This theme dates back a few years and will be the collective chant that will contain something like, "Due to our expansion into the emerging markets, we expect earnings growth of about X% over the next few years" (with X usually greater than 10).  This will be countered by pundits touting their picks as "diversified internationally in the emerging markets". With domestic growth slowing it is almost as if many US companies have been putting it all on black on the global economic roulette wheel, and when "black" is emerging markets - their is a decent chance most will be seeing red.   

Unless you've been living under a rock (hopefully not funded by a subprime mortgage) for the last few years, you have undoubtedly heard of the emerging markets.  As an asset class, they have annihilated any others - look at the periodic table of investment returns to see.  Most asset allocators have moved Emerging Markets from a speculative portion to a much larger percentage of most if not all clients allocations.  Over the past few years, funds have flowed into these markets like Lindsay Lohan to rehab - doubling in 2007 to $40 billion. 

Investors in US Equities over the past year or two have been promised similar returns by the companies whose stock they own, because these companies have expanded into th emerging markets.  This first began through the phenomena of outsourcing that has occurred over the past decade and has been a major investment in labor.  As companies began to reap the benefits of their labor (<---play on words), their bottom lines exploded and they found themselves with massive amounts of cash.  In 2005, as the Fed was raising rates, housing was beginning to wobble, and domestic growth prospects became dim, James McGregor's book, One Billion Customers came out (and many similar followed), and became the bible in how to invest that capital into the biggest emerging market - China.   Since then, every company and their mother is making capital (not just labor) investments in China and other emerging markets and are receiving a higher multiple and given rosier prospects for it.  Companies are now frantically fighting for market share in this new economic frontier and using the weak dollar as ammo for their war. 

The fundamental question that should be asked is not if China and other Emerging Markets have great economic prospects for the future (I contend they do).  Instead, one should ask, "Will investments in these countries be lucrative, if not profitable at all?"  In the 1990's, the hoopla created by the idea of Moore's Law created a mass rush for both individual and corporate investors in technology and technology companies.  The belief at the time was that this exponential growth in technology would change all the rules - and for some time it did.  But investors in the late 1990's and early 2000's found out that although it was true that technology changed everything (it sure did) many investments in technology and tech companies were not that profitable.  For further clarification ask Time Warner about a little company called AOL.  This was due to the fact that it is difficult for business to keep up with the rapid increases in technology.  Sure chip speed can double every 18 months, but ask the company who just bought tons of computers 12 months ago and now much buy more to compete how much they like that speed, or to the guy in 1998, who spent a month's pay on a top of the line PC twice in the span of three years so he could run the crappy Windows 98 instead of his current Windows 95 (Start Me Up, Indeed).  Progress, both technological and economic, does not necessarily turn into profits.  Especially in the manner that most people believe it will. 

Let's examine the phenomenon that we are dealing with today in China.  Chinese consumers have become relatively wealthy over the past few years due to the opening of their markets to the west and the subsequent investment in labor by many manufacturers.  This has in turn spurred many other businesses to develop and the dollars that US and European countries have paid in wages to be invested in stocks.  In turn, many Western investors, hungry for growth, have put their investment dollars to work in these stocks and the stocks have done well.  This has given China tons of capital to employ and created a consumer base with disposable income that needs to find a home.  In turn, US companies (especially large multinationals) have expanded into this market so that they can capture these dollars that are supposedly just itching to buy what they're selling  This supply of dollars (as well as Euros and Pounds and Yen) in China has been translated to a currency that so happens to peg against the dollar enabling this relationship to hold.  It has kept Chinese goods as well as labor competitive in dollar terms as an artificially stronger dollar is able to get more bang for the proverbial buck.  This is THE load bearing wall in the Great House of Chinese (and most emerging markets) Growth because as long as the West keeps supplying labor to China and then purchasing its goods, companies will be able to turn around and capture some of these dollars by doing business there.  If it were truly sustainable, they would be able to do what up until now has been economically impossible - maintain margins in an increasingly competitive environment devoid of macroeconomic consequence.  This is pretty much the definition of "the end of business cycles". 

For some light on how this will most likely turn out, I encourage you to read the 2003 study put out by the Dallas Fed (Yes boys and girls, the very same Fed who brought you such countless treasures as "A Yo Technology", "Flip this House" and "Foreclose this House", as well "Contained", "Have You Hugged Your ARM Today?",  and soon to be a timeless classic "The New Global Economy") called "New Economy Myths and Reality".  In this report, which is uber-applicable to our current state, they write,

Excitement over new technology’s potential for lowering expenses, boosting profits and expanding market share sometimes leads analysts and investors to believe the good times will never end. In the midst of the 1990s boom, well-known MIT macroeconomic theorist Rudi Dornbusch proclaimed, “This expansion will run forever; the U.S. economy will not see a recession for years to come."

What will be the wrecking ball to the aforementioned load bearing wall in China?  It can come from multiple places, but most likely a combination of a few.  I have listed some of them below:

1. The US Consumer Comes Under Pressure.  This will cause a decline in consumption and less Chinese goods to be bought, which are mostly Consumer Discretionary items such as toys, clothes, and electronics.  Less dollars flowing to Chinese manufacturers means less dollars floating around China.  Companies who are banking on those dollars as a market for their products or services are all fighting over a declining supply - not a "great" return on capital situation.
2. The Yuan Appreciates. While this will make US Goods more competitive in the short term, it will cause Chinese goods and labor to be more expensive to the very markets they operate in.  Since the Chinese Economy relies on this as a major boost to their GDP, eventually the consumer will slowdown.  Also, as profitable opportunities arise, even more competition will step in and what was a nice competitive landscape for many US Multinationals will see profits slowly being eroded through pricing pressures.  Although this is inherent to China, any currency instability or shift from the status quo of the past few years (weakening dollar, certain dollar pegs, Yen carry trade, etc) could cause problems for those who have invested in emerging markets.
3. The Emerging Market Stock Markets Crash.  As we have seen throughout history and most recently in the Tech Bubble as well as the Housing Bubble, rising asset prices creates a wealth effect where will spend more because they feel they have more.  If that wealth becomes threatened ,all bets are off.
4. Protectionism.  Washington is abuzz with a backlash against NAFTA and other free trade pacts.  As the 2008 election increasingly becomes more of a populist orgy - expect this to be a major item on the agenda of whoever enters the White House in '08.  This will be detrimental to everyone invested in emerging markets - whether in their 401k or as part of their business strategy.  Also, historically we have tried to exercise control over economies that may be competition to us by flooding their markets with our goods (see Japan, as well as the Marshall Plan for great examples).  China doesn't want to see this and may also take protectionist measures in order to prevent a deflationary spiral like others have seen. 
5. Oversaturation.  Economic history has shown, if there are margins to be had, companies will move in to try to grab market share.  This diminishes both economic and accounting profit.  Up until now, accounting profit has been maintained as economic profit has been going into the red. As competition increases both measures of profit will come increasingly under pressure. Economic profit includes positive and negative externalities.  Growing concern over global warming, rising commodity prices, and increasing geopolitical instability are some negative externalities caused by this phenomena which may soon start to eat away at accounting profit - as protectionism and political measures are taken.

Time will eventually tell whether Bill and Ted's voyage to the emerging markets will be an "Excellent Adventure" or a "Bogus Journey".  I'm sure when Emerging Stocks finally begin their descent, it will be a very hot topic for the pundits and bloggers.  However, I contend that the real issue, when that happens, will be what it will mean to all the capital on US companies balance sheets and earnings flowing into the income statement budgeted overseas to earn a outrageous return which now is in jeopardy and the valuations of many companies who are "not tied to the domestic economy and diversified abroad".  This is cash that could have been returned to shareholders in the form of a dividend, but has been invested in the emerging markets turning a company that should pay a 4% yield with low earnings growth and a low P/E into a no dividend growth stock.  There are many such companies and many investors own them and I believe the market is just beginning to wake up to this reality as Industrials have recently begun to flounder. 

Are these unlikely suspects the tech stocks this time around?  Only time will tell.

Disclosure: Long EEV and FXP.