EMERGING MARKETS WILL SUBMERGE AGAIN!

The 1990's have not been kind to emerging markets, to say the least. From Mexico's tequila crisis in '94 to the Asian flu in '97, from Malaysia's capital controls to Russia's sovereign debt default, from Pokhran sanctions in India and Pakistan, the political carnage in Indonesia and the Luxor massacre in Egypt to NATO cruise missile attacks in the Balkans, the first post-Cold War decade has wrecked havoc on Third World capital markets.

Everything that could possibly go wrong went wrong even in an asset class where assassinations, military coups, civil wars, oil price crashes, bank failures, hyper-inflation, IMF bailout, currency panics and rigged IPO's are routine events of the pathological investment equation. It was a cruel irony that the meltdown in Third World emerging markets happened at a time when investors were swimming in a river of gold on Wall Street and European equities. In essence, the investor in Third World stocks and bonds took colossal risks on his money for miserable returns, played Russian roulette on his savings with a pistol with five loaded bullets in its chamber and was fleeced like a lamb to the slaughter by interlocking cabals of corrupt governments and dumbo bankers.

Sadly, this column's lousiest market calls in 97-98 all happened in the emerging markets because I dissected economics and finance but ignored geopolitics in my valuation paradigms. So I recommended the Pakistan Fund three weeks before the nukes of Pokhran hit the world press. So I tried to bottom fish Russia after Yeltsin signed an IMF accord last June and the Kremlin floated a billion dollar Eurobond in London, Berlinand & Zurich. So I was seduced by Telebras and its telecom model but ignored the political realities of the Brazilian Congress. This mea culpa is all the more bitter because I started on Wall Street in the late 1980's, working on Latin American debt arbitrage and Brady bond syndication work that both benefited the world's poor as well as financed an expensive Manhattan yuppie banker's lifestyle. But politics, not economics, matter most in Third World finance. The ideas of Count Metternich and Niccolo Machiavelli rule the roost, not the homilies of Warren Buffett and the cerebral grand designs of Friedman, Fama, Markowitz and Keynes!

So why avoid emerging markets like the plague now? Eight reasons. One, the credit crunch of '98 continues to afflict the Third World. Sure, Chairman Greenspan's three rate cuts averted financial Armageddon, took us to Dow 9500 and reopened Silicon Valley's IPO window, but loan spreads, risk premia and liquidity crunches are still intact in the Eurocurrency markets for emerging markets borrowers. It is no coincidence that international bankers have blackballed the emerging markets since the panic of 98, with primary debt issuance down 40% since last October alone. Despite all the hype of three Fed credit cuts and "Asia coming back" propaganda, the smart money in Wall Street does not want to touch the Third World. Period.

Two, the existence of the credit crunch means that fiscally profligate Third World governments cannot count on foreign money to finance their deficits and grandoise projects. Since export prospects for commodities as diverse as crude oil, copper, cotton and bananas remain poor, the credit crunch means recession, high real interest rates, debased sovereign risk and Draconian belt-tightening in domestic demand. Without sound macroeconomics and solid GDP growth, bull runs in stock market are impossible. The collapse of oil prices has devastated the economies of the Middle East, Russia and Mexico with no hope in sight. Brazil has the highest interest rates in the world. Pakistan has de facto defaulted on its dollar debt. Indian macroeconomics, despite the lifting of UN sanctions, are as awful as they were on the eve of the Rao-Manmohan Singh reforms in '91. Still dreaming about bull markets East of Suez, India and Pakistan? Dream on.

Three, Third World earnings shock continue. Asia's financial carnage occurred at a time when its Chinese owned conglomerates had leveraged their balance sheets to the hilt with borrowed dollars. In Latin America, the oil/copper/coffee crash, stratospheric real interest rates and capital flight. In the Gulf, bank earnings in '99 will be killed by the collapse of local stock markets, downsizing in petrodollar government project finance, shrinkage foreign trade volumes and, as usual, the leveraged post-bubble property lending hangover. Net-net, Third World earnings are headed much lower.

Four, it is no coincidence that the CRB commodities index is at a 24 year low, that oil and gold have lost 30% since 1996 and that even 5% U.S. GDP growth has meant zero inflation.

Emerging markets are highly correlated with commodity prices and have been ever since the East India Company cornered the markets in Bengali jute and Chinese opium in the 1840's. When deflation hits, they tank like dominoes as they did in 1997-98.

Five, with awful GDP growth, high real rates, collapse in oil prices, valuation models are meaningless. Bull markets require new money, optimism and higher trading volumes. But US and European investors just want to get out of the emerging markets. On Wall Street, appetite for foreign investing in non-transparent, illiquid, badly regulated, rigged and often discriminatory Third World stock markets is zero. Even the smarter Third World elites have squirreled their wealth offshore, in IBM shares, Uncle Sam IOU's and Swiss bank deposits! They know that pension funds and retail investors in the West have gone allergic to Third World investing - permanently.

Six, bull runs in emerging markets are correlated with low Fed funds rates, as in 1992-93. In fact, the rallies we saw since October everywhere from Caracas to Seoul to Hong Kong happened just after the Fed pumped high powered money in the banking system. But in 1992-93, the real Fed funds rate was less than zero, the dollar was on the ropes against the DM and Greenspan was trying to bailout Citicorp and the Bank of America. Not so now. The real Fed funds rate is now 3%, the dollar is king and the giant New York banks are slim and trim. With 5% US GDP growth, another Fed rate cut is impossible. In fact, Greenspan could well hike the cost of money in '99 and this will be the kiss of death for Third World stocks. Look at the price action on US Treasury notes, the implied Eurodollar futures/short dated FRA yield and the steepening of the US yield curve. The bond market has flashed an interest rate alert and the Third World is the loser.

Seven, the investors of the last resort in the Third World were risk addicted hedge funds. Yet after the UBS/Bankers Trust debacles with LTCM or Mexican derivatives, any banker who will margin lend to hedge funds is asking to have is head rolled. The golden age of hedge fund investing is over. So is the golden age of the emerging markets.

Eight, financial crises and bank panics require lower interest rates and structural reforms. But in the emerging markets, the cure is more painful than the disease. Interest rates soared as foreign money fled an masse when Asia hit its financial iceberg in late '97, followed by Brazil and Russia monumental fall from grace. Structured reforms have proved illusive in dozens of emerging markets. Their banking systems, credit cultures, accounting and corporate governance standards are a joke. From Malaysian capital controls to Korea's overleveraged chaebols to Pakistan's bankrupt nationalized banks to Hong Kong's busted go-go Chinese merchant banks, emerging markets are a sorry case in primitive financial regulation and crony capitalism run amok. In even the best of times, investing in such ill-regulated markets is a recipe for disaster. And the spring of '99 is the worst of times.

Eight, now that Russia has defaulted, Malaysia has opted out of the private Eurodollar markets, India and Pakistan have gone nuclear and the IMF has been exposed as a quack financial witch doctor, the "moral hazard" risk in sovereign spreads will rise to new highs. This means a higher, permanent borrowing cost for all emerging markets. Why else do depressed economies have such painfully high credit costs? Because foreign money has gone and international loan and equity new issue markets are shut to the emerging markets. Yet another nail in the coffin for Third World stocks.

Do not be misled by Asia's liquidity rallies since October. With the US dollar bond yield at 5.5%, 120-125 dollar yen, $10 North Sea Brent crude and $280 gold, emerging markets are sure to submerge again. Stay away now but watch and wait. Money making ideas? Stan Chart Bank is a short for a £4 price target. HSBC is a short for a HK 140 target. The Korean KOSPI is a buy at 450 for a 700 target. The Turkey Fund (TKF) is a short at any price. Cheap stocks? Solidiere, Lebanon's property development giant, now trades below book value. National Bank of Oman (NBO) is a strong buy at 3.30 RO, just above book. Telmex (TMX) would be nice at 36-38.

MATEIN KHALID
PORTFOLIO MANAGER
GULF AL BARAKA INVESTMENT LLC

The opinions expressed by the writer are his own and not endorsed by Press Release Network.

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