Friday, August 5, 2011

Emerging-market booms in doubt as China tackles internal challenges - Chicago Tribune

With many American consumers crippled by debt and job distress, investment advisers have urged clients to look past the United States and devote some money to emerging markets.

After all, they have argued in client meetings, not only has growth in China and Brazil been strong while the U.S. and Europe have limped along, but investors still haven't indulged adequately in emerging stocks and bonds, given the tremendous expansion of developing markets. And while U.S. Treasury bonds pay almost nothing and the dollar and Euro have people on edge, the currencies of commodity producers like Australia and Canada have attracted investors seeking alternatives.

But just as the U.S. economy threatens to dip back into recession and investors are asking again where they can find solace and profit, the emerging market argument is fraying.

The central figure driving emerging market strength has been China — yet China is attempting to tame inflation and a real-estate bubble while analysts wonder if the country can maneuver through those economic challenges without disrupting the Asian and Latin American booms it has fueled.

"A slump in Chinese imports is a major risk to global growth," said Arthur Budaghyan, emerging markets analyst for BCA Research. But Budaghyan sees that slump as inevitable. He says much of the strength in emerging market economies has come from selling basic materials to China. Since China has overbuilt housing that is too expensive for the masses to buy, Budaghyan expects demand for commodities to wane.

Already, that's been showing up in materials such as cement. China still consumes the largest amount per capita of any country in the world, but the trend has been slightly down. Also, nickel prices often fall before investors notice weakness in other metal markets, and Budaghyan notes "the latest relapse in nickel prices has been pronounced," possibly a "precursor of material downside in the metals complex."

Mutual funds that invest in basic-material companies have declined about 6 percent in the past 13 weeks, according to mutual-fund tracker Lipper Inc.

China's government has been encouraging construction for the past few years to create jobs as millions of people migrate from rural areas to cities. Speculators have been willing to buy these homes so far, but Budaghyan argues that at some point they will worry about selling them. Then values will plunge and construction will stall.

"Construction companies are overleveraged and will go bust," banks will be left with bad loans, and local governments — which derive 50 percent of their revenue from land sales and construction — won't have the money they need, he said. "Risks are clearly on the downside," he added.

As he spoke in Chicago at a CFA Institute seminar last week for investment managers and analysts from throughout the world, Budaghyan noted that clients are asking whether the downturn in China stocks this year has been deep enough to provide good values. But he suggests investors "stay put." He expects a sharp downturn within 12 to 18 months will create a better opportunity to buy.

"Growth will continue decelerating even if policymakers stop tightening," he said. Consequently, "profits and share prices will remain vulnerable."

Emerging markets have declined about 5 percent since April, but Budaghyan says that it hasn't been unusual for emerging market corrections to be as severe as 25 percent. China funds have declined about 5 percent during the last 13 weeks, according to Lipper, and Latin American funds have dropped about 6 percent.

Analysts have grown increasingly wary of global slowing after last week's manufacturing data showed a sharper downturn than expected. Industrial activity is declining throughout the world, including the U.S., eurozone, United Kingdom, China, Brazil, and Taiwan.

"It is tempting to attribute the weakness to concerns over the sovereign debt crises roiling the euro area and the U.S.," said JPMorgan Chase economist David Hensley. "However, the breadth of the softness is likely more attributable to the weakness in global demand."

Although analysts are recognizing general slowing, few others expect the sharp correction that Budaghyan envisions. To stave off significant slowing in China, Greater China Fund manager William Fong says he thinks the government will begin new initiatives to stimulate consumption and infrastructure building — programs similar to Cash for Clunkers and rewards for buying new appliances. China initiated stimulus programs after the U.S. 2008 financial crisis and fueled a boom that helped insulate emerging markets from the U.S. recession.

Still, Fong is avoiding investments in Chinese banks and property and has less invested in basic-material companies than usual. His favorite sector now is information technology — particularly companies related to items like smartphones. Hand-held devices are popular with a growing middle class, he said.

Investors who think China will be able to avoid a hard landing can participate by buying metals and mining companies, and investors who expect a sharper downturn should avoid those sectors, according to research done by Morgan Stanley strategist Adam Parker. He examined all sectors and found only "metals and mining" are consistently correlated to China. But any company doing significant business with China will be bruised if the country and emerging markets go through the harsh downturn Budaghyan envisions.

Budaghyan is warning investors to avoid currencies in countries such as Australia that depend on China to buy their commodities. Yet, he says, emerging market bonds from Latin American and Asian countries are attractive because interest rates are high now. If the economies cool as China buys less from them, the countries will lower interest rates, making today's higher yielding bonds valuable.

Still, figuring out when a sharp China correction might arrive is not easy.

The investment property market in China "is a complete disaster," Marc Faber, publisher of Gloom Boom & Doom Report, said at the CFA Institute seminar. "But a disaster can be postponed, and they can transfer the debts to the government."

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