Friday Finance - why I'm avoiding Emerging Markets

Source

Last week I discussed the pros and cons of Emerging Markets. I explained why I would take a bet each way, investing about 10% in these markets rather than the 20% that its size would suggest appropriate for an indexing approach.

Recent events have changed my mind.

I’m not going to invest anything in Emerging Markets unless Vanguard Australia offers a product that meets my specifications.

The problem, in one word:

China.

Here’s an article that sums up pretty well what’s been happening.

First the CCP went after billionaire Jack Ma following his critical remarks about the party. His companies were pursued for antitrust violations and have lost much of their value.

Then came the freezing of various platforms for alleged data security issues after they listed or attempted to list in the US.

For me, the final straw was when China suddenly banned all for-profit education, making several online tutoring giants worthless overnight.

The good and the bad

Regulation is one thing. Some of these companies really were monopolistic. There was room for restrictions on private education, as in South Korea which banned cram schools from teaching past 10pm. And data concerns are legitimate.

You can find apologies for the CCP online, with such claims as: “The five year plan signalled all of this! The smart money was already out. These billionaires needed to be reined in.”

Certainly the world does contain tech billionaires who need reining in.

However, one can’t miss the real pattern in these crackdowns: there was little warning and the blows fell heaviest on those stocks listed overseas and in Hong Kong, i.e. on foreign investors.

Ouch. Source

The CCP told a meeting of concerned Wall Street bigwigs that the education thing was a one-off, that their markets would be orderly and nice from now on.

Shortly after, the CCP propaganda arm was making threatening noises about the evils of computer games, suggesting those companies will be next against the wall.

We don’t have a crystal ball, but remember one of the firmest findings of behavioural psychology: past behaviour is the best predictor of future behaviour.

In other words, Xi’s gunna Xi.

Active management?

Some pro-CCP shills online suggest that anyone could have seen this coming by reading the tea leaves. ‘They said they were trying to increase the birth rate, so of course private tutoring was going to be banned!’ Erm, what? That would not have been my first guess.

Some did see it coming. There are online education companies that officially changed into computer companies shortly before the hammer fell. Some Chinese investors got out in time. Good old guanxi and tip-offs.

However, none of the shills seem to be bragging that they got out, nor do they link to their own, previous statements that prove they knew this was coming aside from some very vague tweets that might have meant anything.

Few China experts working for Western funds picked the tech wreck before it happened. In fact, I think none. I heard a finance guru spruiking Emerging Markets on YouTube about a month before they tanked.

As a general rule in life, be very wary of an expert who thinks he knows what’s coming next. No one knows nuffin except insiders and you ain’t one.

Given all this, I don’t see much hope for actively managed Emerging Market funds being able to keep an ear to the regulatory ground and efficiently invest in China.

But China is not the whole of the Emerging Market

No, but it is a bloody big chunk of it. About a third of most indexes.

If you hold a general Emerging Market fund, you have a lot of exposure to a country where entire, massive industries can be banned overnight without warning. That’s pretty risky.

Buy the dip!

Normally, the moment after a big crash can be a good time to buy into the market if you have cash lying around. Plenty of great companies may be available at a discount. Some are advocating this approach.

However, in this case company fundamentals make no difference.

Perhaps TenCent is awesome in every respect. That’s great. It’s also meaningless if the CCP decides the company is getting too big for its boots.

In the West, markets are clearly imperfect but governments cannot mess with them however they want. In fact, most of their messing is to prop them up. You see, rich people have their money in the market. Piss them off and the government will fall.

In China, the CCP has greater scope and different motivations. It would drag the people back into famine before giving up power, so smashing its own biggest companies for increased political security is nothing in comparison.

It would have been good for us to realize that a few years ago. As it happened, the reality of market capitalism with Chinese characteristics hit us a minute too late.

In any case, rich Chinese invest most of their money overseas (for reasons we now understand) so the CCP will cop less blowback from domestic elites for these random crackdowns.

The decision

You can argue all you like about why China did what it did and how it was actually based, or whatever.

From my point of view, I no longer see China as a real market where companies will transform resources and labour into profit reliably over the long term.

Instead, the private sector plays poor cousin to a regime that will calmly destroy the economy if it calculates a political advantage in doing so.

Even expert fund managers did not detect this trouble in time so there’s little hope for stock pickers, let alone us spazzo indexers.

If Vanguard Australia offers an ex-China Emerging Market fund for a reasonable fee, I’ll have another look. Until then, I’ll stay away.

It’s a pity to avoid Taiwan and South Korea but so long as they’re lumped in with China, I’m not touching them.

Sure, Emerging Market P/Es are good, but now we know why.