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US Remains Most Attractive Market

Since the end of May, emerging markets funds have seen investors pull out nearly USD 40 billion, leading the MSCI EM Index to fall by 11% in USD terms. In particular, Russia lost 16.5%, Brazil retreated by 21%, China dropped 11.5% and India was down by 10%. Meanwhile, growth in the U.S. market continues – over the first half of the year the S&P rose by 12.5% to reach a new high, and it looks like we will see a further rally through the end of the year.

Certainly, U.S. companies have many advantages over their emerging market counterparts. First, the quality of corporate governance is much higher, and they are willing to share profits with shareholders. Second, the level of debt has fallen significantly, dropping from two times equity in the 00s to around a debt/equity ratio of 1 in 2012. In developing economies, in contrast, cheap dollars from the Fed stimulated an increase in debt. Third, their exposure to the economic growth of developing countries is no less than that of local players, but the diversification of local risk is considerably higher.

Given market trends, many investors are wondering whether it’s time to sell U.S. names and start buying battered emerging market stocks. After all, multiples on U.S. issues are once again exceeding those of use of emerging market stocks by the most since the mid-2000s. But the answer to that question is no. American stocks should significantly outperform issues from other countries, especially emerging market names. Moreover, the situation in the financial markets may be similar to that during the crisis of 1997-1999, when overheated economies (Asian and others) began to quickly lose momentum, defaults began and stocks dropped in value, but the American economy grew for another three years, until the internet bubble burst.

There are several reasons for continuing declines in emerging markets. First, the Chinese economy has put the brakes on. Recent statements from the Chinese leadership offer hope for only a slight “fine tuning” and isolated investment by the government in the economy. Consequently, don’t wait for any new long-term upward trend in raw materials prices. Second is the expectation that quantitative easing may be curtailed. An end to QE and even smooth growth rates in the U.S. may eventually kill the dollar carry trade in emerging market currencies, which for global investors could signal an increased risk of devaluation. 

In addition, the U.S. predicts accelerating GDP growth, from 1.8%, 2.7% next year and 3% in 2015, while in BRICS countries are expected to stabilize at 5.9%. This is much lower than the 2010-2012 figures. In such a case, a smooth cutback in QE won’t harm the US, but will be damaging to emerging market countries. Moreover, don’t forget about Dodd Frank and the Volcker Rule, Basel III “stress tests” by central banks, required cutbacks in risky assets, with emerging market securities first in line. Moreover, banks can severely limit speculation in the commodity markets, which will hit commodity prices.

Finally, thousands of protesters in the streets of Brazil, Turkey, Egypt and other countries not only fails to stimulate foreign investment but pushes local capital into safer havens such as New York, Zurich and London.

Therefore, U.S. stocks should continue to be the foundation of long-term portfolios, while emerging market names are more suited to speculative trading with a 1-2 month horizon. Where we’ll see price appreciation in the U.S. is not a simple question, because the U.S. economy is set to undergo significant structural changes. However, the consumer sector, pharmaceuticals and health care, construction, “new" (including alternative) energy, semiconductors, the computer industry, communications and media are all likely leaders. 

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