Falling BRICs

After enjoying a fantastic rally for the last few years, the BRIC trade is coming to a close. A look at the equity markers in 2010 said it all. With the exception of Russia, three of the four BRIC equity markets underperformed the Dow and S&P 500. Russia benefited from the strong rally in commodity prices. Fortunately, the BRICs didn’t lose all of their appeal in 2010. Emerging market fixed income assets fared well. A combination of quantitative easing, a surge of new issues and strong credit conditions helped generate demand for emerging market bonds. However, the rally ran out of steam at the start of 2011. Inflationary pressures started building across much of the developed world and portfolio managers began to prepare for a reversal in monetary policy. Inflation in the U.K. is running at 4%, and analysts are pushing up their inflation targets for the Eurozone. Instead of acting in a proactive manner, the ECB and the Federal Reserve are holding off on raising rates. They are concerned about prematurely derailing their nascent economic recoveries. However, several prominent ECB and Fed officials are voicing concerns. The problem is that the longer that the monetary authorities delay in raising rates, the more that they will have to tighten once they are forced to act. This will push many emerging market bonds under water, particularly longer duration assets. Moreover, the higher quality sovereign and corporates are trading at very tight spreads, and a sharp increase in benchmark rates to a 4-5% range will trigger a large selloff. The recent outflows from emerging market bond funds affirm this point of view. Just like many other financial fads, such as Dotcoms and mortgage backed securities, the BRIC mania is coming to a close.

The problems in the Middle East also helped stimulate the selloff. The sudden collapses of Tunisia and Egypt were grim reminders that emerging market countries are inherently unstable. Weak domestic institutions become all too apparent during periods of political transitions. The Egyptian collapse was particularly remarkable, given that it was recently showcased as one of the new Frontier Markets that promised to be the next set of high flying countries. Moreover, the BRICs are looking a bit frayed. The stellar macroeconomic numbers of less than 4 years ago are no longer there. Most of the Latin American economies are carrying sizeable current account deficits. The fiscal discipline is also gone and consumer lending has stretched bank balance sheets. Furthermore, most emerging market currencies appreciated sharply during the last few years, leading to a noticeable loss of competitiveness. Last of all, many of the emerging market countries, such as India, China, Brazil and Colombia, are overheating. Their central banks are tightening monetary policy, thus pushing their economies into a downward trajectory. At the same time, macroeconomic conditions in the developed world are slowly improving. The household savings rate in the U.S., for example, tripled over the course of the last three years to more than 4%. Most of the European countries are getting their fiscal accounts under control and cleaning up their financial systems. Likewise, there seems to be a strong consensus that the European Union will not force any country to abandon the euro. All of these factors are giving investors more confidence in the developed world. Therefore, this is the reason why there is a major rebalancing of global portfolios underway. 

Some pundits argue that investors should remain engaged in the emerging markets due to the continued increase in commodity prices. Years of fiscal and monetary expansion are clearly fuelling global inflationary pressures, and this is one of the major reasons why commodity prices continue to rise. However, not all of the emerging market countries are pure commodity plays. Commodities play a dominant role in some economies, such as Russia and Chile. However, they are a smaller component in other countries, such as Brazil and Colombia, which are just starting to expand their commodity sectors. Many emerging market countries still tend to have very closed economies. Therefore, the real impact of a significant change in commodity prices is muted. This is the reason why most emerging market countries continue to underperform despite the hot demand for natural resources. We are now at the inflection point of the emerging markets business cycle. Most of the countries are starting to enter a contractionary phase. Likewise, the developed world is showing the initial signs of an economic recovery. This is why emerging market investors and fund managers should reduce their exposure to risky assets and duration, before it is too late and they are clunked on the head by a falling BRIC.