Will the next bubble be in emerging markets?
by Manas Chakravarty
Now that the great housing bubble in the US is bursting, attention has already shifted to where the next bubble will be. A large number of stock market strategists believe that it will be in emerging markets.
Why should we have another bubble? That’s an easy one—with the US Federal Reserve cutting rates by 50 basis points on Tuesday, Ben Bernanke has sent a powerful signal that he is willing to inject liquidity into the markets, brushing aside arguments that those who had lent imprudently should be left to stew in their own juice and that helping them out would create moral hazard, which would encourage further irresponsible risk-taking.
It’s a clear admission that the notion that markets have to go through periodic purges to get rid of their excesses is a non-starter in an age when financial markets are so large that they’re the tail that wags the economy dog.
There’s a school of thought which says that the markets have been having one long serial bubble for decades. It all started with the oil price rise of the 1970s, with the Gulf oil producers accumulating vast surpluses, most of which were funnelled to US banks. That led to a big rise in money supply in the US, setting the stage for a heady bout of lending by mortgage companies, which culminated in the Savings & Loan disaster of the 1980s.
Also at the same time, oil surpluses were lent by the banks to governments in Latin America. Later on in the 1980s, when interest rates rose and the dollar appreciated, these loans turned bad and led these countries into a debt trap.
The 1980s are often spoken of as a “lost decade” in terms of development for Latin America. In the US, the rise in interest rates led to the bust in the savings and loan associations and the biggest rescue operation by the US government in history. That was when, worried by the continuous rise in the value of the dollar and the loss of competitiveness to Japan, the US forced the Plaza Accord down Japan’s throat, forcing it to let the yen appreciate. That led to a fall in the value of the dollar, capital repatriation to Japan and a lowering of interest rates there to rock bottom to keep exports going. It created the mother of all bubbles in Japan, with the Nikkei going up to a stratospheric 39,000 and real estate values going through the roof.
But all bubbles have a nasty habit of popping, and when the Japanese bubble burst, it sent the country into a prolonged depression from which it is yet to recover.
After the bust in Japan, the Asian tigers became the next bubble, with capital flowing like water to these emerging markets. When that huge bubble burst during the Asian crisis, the money hotfooted back to the US, where the tech bubble was waiting to happen.
We all know how that ended and how Alan Greenspan’s rate cuts set the stage for the housing bubble in the US and, in keeping with the spirit of globalization, led to the first truly global bubble.
Coming back to the present, there are two arguments why emerging markets will be the next bubble. One of them, long supported by Michael Hartnett, global emerging markets equity strategist for Merrill Lynch, is that the rate cuts will lead to additional liquidity which will flow into emerging markets with their fast-growing economies.
Their argument is the familiar one of the current credit crisis being 1998 in reverse: while Fed easing in 1998, when there were massive credit problems in Asia, led to a flood of liquidity flowing into largely US tech stocks, this time the credit crunch is in the US and so the money will go to emerging markets.
The other, related view is the one advocated by research firm CLSA’s Russell Napier, who writes: “A new world order is emerging, where Asia and probably Europe lead global economic growth. The future increasingly looks like one where foreign private capital will seek non-US dollar exposure, forcing foreign central bankers to step up support for the US dollar and domestic liquidity creation. Such a seismic shift in global financial markets augurs the birth of a new world order.” In other words, the weak dollar will force central banks to intervene in the foreign exchange markets to mop up dollars and that will release a flood of liquidity into their markets, creating a bubble.
Where’s the catch?
The catch is that the US economy must avoid a recession. Says Hartnett: “Financial crises followed by recession have resulted in bear markets (e.g., US/S&L 1990, Japan/land bubble 1990, US/tech collapse 2000). In contrast, financial crises not followed by recession have resulted in great buying opportunities (e.g., 1987 crash, Mexico 1995, Russia/LTCM 1998). We believe the latter will prove the case this time around for emerging markets.”
But won’t the US slowdown affect other economies as well? It will, but it’s all a question of relative performance. And a country like India, not very dependent on export demand, should do well.
What about the fact that the price-earnings multiples of markets such as China and India are already very high? It’s in the nature of bubbles and manias to forget about valuations. Remember the valuations of tech stocks at the height of the so-called “New Economy” bubble? If Merrill Lynch and CLSA are right, the blowout phase of the bubble could be just beginning.
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