2011 has so far been a year of taking one step back in the hope of taking two steps forwards over a longer timeframe. Fund pickers have been happy to take profits in emerging markets, and if they have re-invested it has been with a more selective approach than in previous years. No longer can you take a blind punt on developing markets and expect to double your returns; the art of investing with greater discretion is a vital skill, particularly given overheating fears.
For Skandia, the belief that, despite widespread fears, China may have actually slowed in response to tightening monetary conditions and achieved a “soft landing” is welcome news.
“In China, we think that inflation is close to peaking because we expect food price inflation to fall in the second half of the year,” they say.
“A second half decline in Chinese inflation could be the trigger for a sustained period of Chinese and Asian equity market outperformance.”
Positive signs, though that does not stop investors being nervous. Franklin Templeton’s Mark Mobius, perhaps the most recognised and respected emerging markets investor, spooked investors earlier this year with his warnings that any further rises in inflation and higher unemployment could prompt social unrest in China.
Derivative dangers
I met up with Mobius this week but, rather than repeating the concerns about inflation, interest rates and overheating property markets that we have all heard before, the biggest worry for him appears to be more of a hidden danger – derivatives.
“When I talk about a bear market, I am not talking about 20% drop, I am talking about a 30% down turn. If you consider a 20% drop to be a bear market, then you have bear markets almost every month or at least every quarter because the volatility is so great. You must remember that with $600tn in derivatives out there – 10 times more than the total GDP, there is going to be volatility.”
“Nowadays one of the first questions we ask companies is what derivatives do they have because these companies can lose a fortune on derivatives, and many have. We will know the structure of the company in terms of what they produce in goods and services, and where they are located. But then we have to find out trends from the balance sheet and profit and loss statement. And if those trends are broken in some way or are out of line with the industry then we suspect that something may be amiss, then that is the first thing we will ask about.”
As you would expect from somebody who has been investing in emerging markets for most of his life, Mobius is still enthusiastically bullish on the long-term prospects, from the BRIC powerhouses down to the frontier markets which excite him most today. However, it was clear from our conversation that it was difficulties on a stock level – dishonest or incompetent company management – that had caused him the most problems over the course of his career.
Economists and asset allocators can debate until the cows come home about how central bank policy and macro shifts will influence the emerging markets story, and that is all entirely relevant, but locally-placed stock pickers like Mobius are celebrated for good reason. No matter the inherent volatility of a market, there will always be unprincipled companies willing to take you for a ride of their own.
You can read a full write-up of my interview with Mobius in the forthcoming July issue of Portfolio Adviser.
