beyondbrics

As beyondbrics has reported over the past several weeks, sentiment on global emerging markets has been picking up strongly, with investors once again pumping money into emerging market funds.

But not everyone is bullish. John-Paul Smith, strategist at Deutsche Bank global market research – who describes himself as “probably the only structural GEM bear out there” – warns in a report published on Tuesday of “a new phase for GEM” in which EM equities will appear less attractive to investors than stocks in developed markets, especially the US.

Smith’s argument is based on the view that developed markets face a slowdown in growth at the same time as emerging governments adopt increasingly heterodox policies to deal with inflation. Added to this, he says, is increasing state interference in many of the emerging world’s biggest companies, producing a situation in which emerging companies will be worse placed to deal with challenges in their markets than their developed market peers.

“The non-financial sector in the US is in exceptionally good health,” he told beyondbrics. “In a normal environment it would be investing heavily at home now. But generally companies have been putting resources into cash, restructuring, and investing in EMs. And conditions in the global economy over the medium term should favour the more flexible and innovative US consumer companies.”

Smith says global growth will slow because of a spreading perception in the developed world that there are big fiscal problems that remain unresolved. “Even if the US does not get to grips with its deficit, the widespread knowledge of how bad that deficit is will have a pronounced effect on business and household confidence,” he says.

That will trigger a slow-down in commodity prices – hurried along by the gradual removal of China’s fiscal stimulus.

“The only reason GEM was resuscitated after the global crisis was the efforts of the Chinese government. I’m not suggesting we’ll see a fall [in commodity prices] of the kind we saw after the Lehman event but the effects of a massive fiscal and banking stimulus in China are still reverberating and there’s nothing that will replace that.”

Looking further back, he says governments and companies in emerging markets are wrong to imagine that the world is returning to business as usual, meaning the debt-driven growth that fuelled the global economy before the crisis.

“EM governments and companies became addicted to top-line growth between 2002 and 2007 and we’re just not in that environment any more. We had a mini-echo of that as the Chinese fiscal stimulus came in but that echo is fading away.”

Deprived of growth, governments that adopted counter-cyclical policies – ie, heavy spending – during the crisis have found it hard to change them during a recovery. This is storing up trouble ahead, Smith argues, as well as adding to inflationary pressure now. Reluctant to raise interest rates – though many have had no choice – they have turned to “macro-prudential” measures such as loan taxes, reserve requirements and capital controls.

“A lot of governments have been desperate to fight inflation without taking rates to market clearing levels,” Smith says. Part of this desperation has been seen in increasing interference in state-run and private sector companies. Two obvious examples are in Brazil: Petrobras, the national oil company, and Vale, the mining giant.

The upshot? US companies, and other developed market rivals, will take advantage of their agility to pounce, and EM companies, hemmed in by government controls and uncompetitive policies, will struggle to compete.

A contrarian view. And a sobering one.

Related reading:

Fund flows: Weak dollar, EM gain
Private equity: Brazil is hot