"BRICs Priced For Economic Meltdown"
Comment of the Day

July 04 2012

Commentary by David Fuller

"BRICs Priced For Economic Meltdown"

Despite the headline being an exaggeration, this article from Bloomberg provides a reasonable summary of the current bull and bear arguments for the respective merits of BRICs versus the rest. In other words, the author is reporting differing views rather than selling a particular theme. Here is the opening:
The biggest emerging markets are contributing more than ever to the global economy as their proportion of the world stock market shrinks, leaving investors with the widest valuation gap in seven years.

Brazil, Russia (INDEXCF), India and China, known as the BRICs, will comprise 20 percent of the world economy this year after growing more than four-fold in the past decade, International Monetary Fund data show. At the same time, their combined stock-market value has dropped to a three-year low of 16 percent of the total invested in equities, according to data compiled by Bloomberg.

To Jim O'Neill, the chairman of Goldman Sachs Asset Management who coined the term BRIC in a 2001 research report, the 4 percentage point difference makes stocks in these markets irresistible. The last time the gap was this wide, in 2005, the MSCI BRIC Index (MXBRIC) jumped 53 percent in 12 months, more than double the gain in the MSCI All-Country World Index. (MXWD)

"Unless we are seeing a major collapse of those economies, it's a huge opportunity for investors," O'Neill, who helps oversee $824 billion, said in a June 28 phone interview. The BRIC stock markets may double by 2020 as their share of world gross domestic product increases to about 27 percent, he said.

Combined GDP in the BRICs will rise to more than $14 trillion this year from $2.8 trillion in 2002, according to the IMF. Their equity value, which includes locally-traded shares and companies based in the BRIC nations with primary listings abroad, has dropped to $7.6 trillion from $9.5 trillion a year ago, when they made up 18 percent of the global total, according to data compiled by Bloomberg.


The retreat has pared what was a 180 percent increase in the MSCI BRIC index since October 2008 and reflects concern that economic growth is slowing, according to John-Paul Smith, an emerging-market strategist at Deutsche Bank AG in London. Mutual funds that invest in BRIC equities, which recorded about $70 billion of inflows in the past decade, have posted 16 straight weeks of withdrawals, losing a net $5.3 billion, EPFR Global data show.

While the BRIC economies expanded by 4.8 percent on average during the first quarter, more than double the pace in the U.S., their growth decelerated from 6.8 percent a year earlier.

Falling stock markets suggest the slowdown will worsen because share prices are a leading indicator of economic growth and corporate profits, said Michael Shaoul, the chairman of Marketfield Asset Management in New York. The $2 billion Marketfield Fund (MFLDX) has topped 99 percent of its peers this year in part because of bets that emerging-market shares will retreat.

"Equity markets have started to anticipate much more difficult economic times in these countries," Shaoul said in a June 28 phone interview from New York. "The balance of risks is to the downside."

David Fuller's view There is more disagreement in the article above but I imagine that you get the idea. Anyone interested in this subject will be able to fashion a coherent argument for or against BRICs or any other growth economies, versus Western Europe or the USA.

For instance, BRICs have growth but does that matter today if these economies are still slowing? Even if BRIC companies have greater earnings growth - a debatable point, will foreign investors receive a fair share of the rewards in these less regulated economies? Are not political risks greater in BRICS and other growth economies?

Conversely, Europe has the best valuations but how long will we have to wait for any GDP growth, and are the dividends sustainable? The US is a proven 'safe haven' in times of stress but with a redistributive administration in power and the current president leading in the polls, how many additional overheads will be siphoning off corporate earnings? What about the soaring mountains of government debt in both Europe and the USA?

I could go on but you get the point. Fullermoney is passionately interested in the debate, for its insights and also potential to be a contrary indicator at extremes of sentiment. However, we try not to take sides in subjective arguments. We also find that we are more objective when we manage to avoid having favourites.

My preferred default position when considering asset allocation, over at least the short to potentially lengthy medium term, is to view markets in the manner of a technical naturalist. Think of David Attenborough observing the herd. In other words, let the markets themselves show us who is leading and in which direction.

I find the current evidence surprising, but then markets are full of surprises, which is part of the fun not to mention challenge. Looking at these 5-year weekly charts of Brazil, China, India and Russia, we see that India is currently showing the best relative strength, by virtue of its recent push back above the 200-day moving average. There is not much difference between the patterns for Brazil and Russia, although the former encountered support above the 2011 low. China is still lagging in relative performance, although if we substitute the Hong Kong Hang Seng Index, because most of us who are not Chinese citizens would invest there rather than on the mainland, it moves into the second best overall position by approaching a test of its MA.

So India currently has the better performance among BRICs, despite being castigated by the press and analysts (a contrary indicator?), and Standard & Poors has mentioned a possible downgrade. However, the comparison that matters most, in my opinion, is with the US S&P 500 Index. Clearly, the US stock market continues to show relative strength against the BRICs. For the four BRICs or any other indices to show significant medium-term relative strength, I suggest they also need to outperform the S&P 500, which due to its greater liquidity generally moves at the pace of a supertanker rather than a speedboat.

It will have occurred to you that I am showing three of these indices in their national currencies. Exceptions are Russia's RTSI$ which is calculated in USD, and while the Hong Kong Hang Seng Index is calculated in HKD, that remains pegged to the USD. Some of you may prefer to compare all the BRICs in a single currency, namely USD. That comparison negates India's recent relative outperformance and Brazil is weaker still. China in USD remains an underperformer. As a China proxy, the USD-pegged Hong Kong Hang Seng Index shown above outperforms other BRICs but not the S&P 500.

In the global beauty contest, fashion stakes which are so important in terms of short to medium-term performance, I think most investors will look at them in their local currencies, and then decide whether or not to hedge currency exposure. For this reason I prefer to assess equity price action, from relative performance to trend consistency, in local currencies.

My conclusion - Based on the latest evidence India and Hong Kong as a China proxy are currently the more promising BRICs. However, for the best gains we will have to wait until they also outperform the S&P 500.

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