Hedging Emerging Market Bets

                                                by Elliott R. Morss

Introduction

For almost two years, I have invested in emerging market countries, both as a bet against the US dollar and because their growth rates are higher and debt levels lower than the US, Europe, and Japan. I am a long term investor. I don’t have either the computer power or data to compete with short term traders. And for long term investors, important things don’t change quickly. But every so often, it is worth reassessing any strategy.

I also believe there is considerable merit in the random walk theory that says all information is immediately reflected in stock market prices so the results of stock market picks are pretty random[1]. But as a global economist, I derive undeserved satisfaction from infrequently reviewing the global economic situation and recalibrating my investments based on what I find.

The Global Economic Situation 

According to the IMF, nothing much has changed since 2009. As Table 1 shows, advanced are nations still struggling with recession, government deficits and debt while emerging nations have moved on. Ceteris paribus, this would suggest investments in emerging markets.

In my last article, I looked at prospects for the US dollar. With an unemployment rate just below 10%, there is no threat of inflation (and a consequent dollar weakening) from excessive domestic demand. Internationally, it depends on whether there will be offsets to the US trade deficit projected to grow back to $600-$700 billion as the US emerges from a recession.

There are two possible offsets: governments buying more US government debt and private portfolio purchases of US securities: 

• On governments buying more US debt – Overall, the Treasury estimates that foreign governments hold more than $4 trillion of US government debt, with China holding $1.4 trillion and Japan holding $929 billion. Will they continue buying enough to offset the US trade deficit? The China Daily has reported China foreign currency reserves at $2.5 trillion, of which two-thirds are already invested in US government debt. I believe it is highly unlikely foreign governments can be counted on for a significant offset to the US trade deficit going forward.

• Private portfolio purchases – only a few years back, private foreign investors’ purchases of US securities constituted a major offset to the US trade deficit. But times have changed: their purchases have slowed down, and more importantly, as Table2 indicates, US investors are purchasing foreign securities in significant amounts.

Note that even in 2007, US investors were investing heavily offshore. And after the bank panic, Americans are investing heavily offshore again. Because of this, the private sector offset will get smaller: Americans will continue to invest offshore and foreigners will probably not buy private US securities at the rates they have in the past.

In sum, with both offsets to the US trade deficit falling, I conclude the dollar will continue to lose value and so “bets against it” are warranted. Overall, I conclude that emerging market investments still make sense, both because their economies are growing rapidly and because they are “bets against the dollar”. But I also want to offer a couple of hedges.

Hedge #1 – Real Estate

Real estate prices are falling; sales are up. I believe this the beginning of the final real estate sell-off. How can real estate be a hedge? I don’t know much about real estate, so I asked someone who does. Brad Case, Ph.D., CAIA is Vice President, Research & Industry Information for NAREIT, the National Association of Real Estate Investment Trusts (www.reit.com).

Elliott: Tell me about the real estate cycle.

Brad: The commercial real estate market cycle is long, about 18 years; the last one was 17 1/2 years, give or take one quarter depending on which measure you use. REITs typically move through downturns quickly, but the last one was extraordinarily severe and lasted 25 months. That still leaves roughly 16 years of upturn, and we’re now less than two years into it.

Elliott: How about real estate investments?

Brad: Although REITs have gained 189% from their market bottom on March 6, 2009, they’re still down 22% from their pre-downturn peak on February 7, 2007. Real estate operating fundamentals (occupancy rates, rent growth, etc.) are at or just past their worst point. That means that earnings growth seems likely to be strong over the next several years as operating fundamentals improve.

Hedge #2 – Sin/Entertainment

I have written extensively about the economics of global entertainment. My findings are that we spend more on drinking, entertainment drugs, sex (prostitution/pornography), and smoking than any other entertainment categories. What is most interesting from an investment perspective is that some of these activities are highly addictive and consequently are recession resistant – cigarette smoking is the best example. Drinkers will keep drinking but can choose cheaper beverages in a recession. But there are other entertainment categories that are highly cyclical: consider gambling: in good times, gamblers take their families to gambling “resorts”; in bad times, gamblers stay home and gamble online. Consequently, Las Vegas is in dire straits while Macau, where the global recession is a faint memory, is booming.

So what do we know: sin/entertainment is not going away, and with such a mix of cyclical and non-cyclical activities, it should be a good hedge against just about anything.

Investments 

     1.  Current

My emerging market holdings are set forth in Table 3, along with their one and three-year performance. Only Korea (still down 5%) has not yet recovered all its losses from the financial meltdown. Looking over these investments, India has had a very large run-up. I am considering liquidating this position.

Brazil’s stock market has not performed well. But I view it as the strongest country in the world so I will stick with it. 

     2. Hedge #1 – Real Estate

Table 4 presents real estate options. I am not taken by the last three because of their high price/earnings ratios. FRIFX makes sense to me. With a dividend yield of 5.1% and real estate earnings expected to grow in future years, I see it as an excellent investment.

 Brookfield is not your typical real estate development company. It invests in: 

• commercial office properties;
• hydroelectric power generating facilities;
• infrastructure assets – approximately $15 billion of total assets in transportation (ports, rail lines), utilities (electrical and natural gas transmission), and timberlands.

It also develops commercial and residential properties and engages in real estate finance. Over the last two years, it has been active buying up discounted properties. It has investments in the U.S., Canada, Brazil, Australia and Europe.

I like the company, its mix of investments and its global reach. 

     3.  Hedge #2 – Sin/Entertainment

There is no perfect investment for this, but the Vice Fund is not bad.

Its investments include tobacco, alcohol, defense and gambling. As can be seen from Table 5, its performance is not correlated with the market. I view it as a good secondary hedge.

DISCLAIMER:  I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell an asset.

[1] Burton G. Malkiel, “A Random Walk Down Main Street”: W.W. Norton).

Related Article

The Future of the Dollar:  What International Transactions Tell Us  by Elliott Morss

Elliott Morss has a broad background in international finance and economics.  He holds a Ph.D. in Political Economy from The Johns Hopkins University and has taught at the University of Michigan, Harvard, Boston University, Brandeis and the University of Palermo in Buenos Aires.  During his career he worked in the Fiscal Affairs Department at the IMF with assignments in more than 45 countries.  In addition, Elliott was a principle in a firm that became the largest contractor to USAID (United States Agency for International Development) and co-founded (and was president) of the Asia-Pacific Group with investments in Cambodia, China and Myanmar.  He has co-authored seven books and published more than 50 professional journal articles.  Elliott writes at his blog Morss Global Finance.