The Year of Emerging Markets

 | Jan 02, 2014 | 2:00 PM EST
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Back about 2005, there was this idea that countries like China, Russia, India, and Brazil would outperform developed markets over some extended period of time. Back then, we talked about it constantly.

Countries like China exported goods to the developed world, and we, in turn, exported debt. This virtuous circle continued for some time, until about the last year or two when China suffered from over investment and bad investment, Russia's political climate got scary, Brazil had a cyclical slowdown and India had a currency crisis. But the entire emerging world had a tough go of it in 2013 -- even EM darlings like Mexico, where the heretofore bulletproof peso depreciated 10 percent or so.

The funny thing is that the main reason people were betting on emerging market growth in the first place still persists today. The emerging market countries have, in many cases, strong or strengthening rule of law and property rights, negligible debt and deficits, smart, hard working populations and competent governance. Meanwhile, the decaying, corrupt, bloated West is drowning in debt. The margin calls have stopped, for the time being, but Europe is not fixed and interest rates in the U.S. are rapidly rising.

It is funny to watch the emerging markets narrative change over time. Back in the 1990s, people considered EM to be an almost non-investible asset class, countries that just blew themselves up left and right. Russia, Southeast Asia, and Argentina were all examples of this. Then came the growth story, and people could not get enough of the BRICs.

More recently, you have visions of China with these ghost cities and state-owned enterprises and command capitalism. The ghost cities story is pretty stale/expired by this point and was way overblown. China is in the middle of moving 600 million people from the countryside to the cities. This is free-market blasphemy, but a competently-run planned economy can outperform clownishly-mismanaged capitalist ones for long periods of time.

So the big macro trade over the last year or two was short iShares MSCI Emerging Markets (EEM) and long SPDR S&P 500 ETF (SPY). That worked for several thousand basis points. But I think people are going to wear out their welcome in that trade, because the debt issue will once again move to the forefront in 2014. Our deficit has come down from about 10 percent of GDP to about 5 percent of GDP, mostly on tax increases.

But you can only increase the tax burden so much before diminishing returns kick in. We've never seriously tackled spending, and it is starting to look like pretty much the entire country's medical expenses is about to go on-balance sheet. My personal prediction is that the deficit is going to explode in the next few years.

That would be something, because we no longer export debt the way we used to -- China and Japan are no longer the marginal buyer. In fact, the Fed is pretty much directly financing the government at this point, and they're tapering -- which perfectly explains the increase in interest rates.

My guess is that in 2014 we have an interest rate crisis of sorts, with the bond market intimidating people for the first time in 20 years. Massive debt burdens and currency devaluations are supposed to be the last refuge of failed banana republics. When it starts happening here, people will look to emerging markets -- for stability, of all things.

 The two big emerging market ETFs are EEM and Vanguard FTSE Emerging Markets (VWO). I think they will outperform SPY this year.

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