The fundamental picture in key emerging markets we follow is solid and holds great promise to deliver superior returns over the long haul. But our favorite emerging markets are on the periphery of the developed world — Europe and North America — which is not in good shape. Any shocks at the core will ripple out to affect the periphery. And unfortunately, we have little choice in the matter because the world economy is the most interconnected it has ever been.
This is precisely why I am paying close attention to Europe and so should you. The decline below the USD:EUR level of 1.23 as I type this (that level is important as it stopped the selling in the fall of 2008) suggests that this crisis is still ongoing, whether we like it or not.
However, we are seeing initial signs of stabilization, and I certainly hope we will see more. In my view, there are two possible scenarios:
If Europe Is Contained, the BRIC Rally Will Be Monstrous
If this crisis in Europe is contained — and I do hope that this is the outcome — the results will be super bullish for BRIC equities. Developed world central banks have ultra-easy monetary policies crudely dubbed as “printing.” All this printing results in capital seeking the best returns, which is why it ends up in Asia and BRICs at large. It also ends up in gold bullion considering that the market believes that Bernanke and Trichet are aiming to raise the inflation rate in the developed world — and they are.
BRIC equities have seen few gains in 2010, but their economies are growing rapidly, which causes earnings for companies geared towards BRIC economic growth to grow even faster. These are the types of stocks we focus on in Asia Insider. While the crisis in Europe rages on, BRIC stocks may go down despite rapidly rising earnings.
In the end, however, they are likely to rally much faster than any developed world markets. Last year is a good example demonstrating how BRIC market can outperform their developed world brethren.
If Europe Is NOT Contained, BRICs Will Still Rally — With a Lag
This is the outcome that I hope we can avoid, but the possibility also means that we have to be prepared. The only investments that worked in the fall of 2008 were U.S. Treasury bonds and gold bullion — not gold stocks. Long-term U.S. Treasuries are investable via the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT) and gold billion via out favorite SPDR Gold Trust (NYSE: GLD). While a sharply rallying Treasury market and a sharply rallying gold market — which we have both at present — may seem like a contradiction at first sight, they are to be expected in times of a credit crisis.
When credit stopped flowing in 2008, the most reliable income stream became the coupons paid by the U.S. Treasury department. The Ponzi-like characteristics of those coupons are still here — the U.S. Treasury has to issue more debt in order to pay the interest on the existing and growing debt pile — but the system works for the time being.
In the world we live in, U.S. Treasury bonds are much better than any euro-denominated debt, which why Treasuries are rallying. Japanese government bonds clearly demonstrated over the past 20-years that issuing debt to pay the interest in growing debt pile can work for a long time with ever-declining long-term interest rates. The Japanese 10-year bond yields bottomed out at 0.39%.
Ultimately, this strategy of ever-growing government debt backfires. If the government tightens its belt to straighten out its finances, this will likely create a severe recession and deflation, like we will have in Greece. And if the central bank buys too much of that debt it creates inflation, as we are likely to have at some point in the future. This is why the policies of the developed world central bank are catalysts for causing the gold price to spike further. At present we have the unique situation where gold bullion is rising in all currencies — yen, euros, dollars, Swiss francs et al.
This all-currency rally in gold bullion was the key signal that I have been waiting for to mark the beginning of the super spike in gold bullion. It’s here.
Long BRIC Stocks/Short E.U. Financials
All risk parameters that I follow — VIX, LIBOR, bond spreads, etc. — are suggesting that the tensions in financial markets are increasing. Focusing on defensive strategies should pay off it the present environment.
One way investors in BRIC equities that can hedge their exposure to the E.U.-created turmoil, in addition to being long U.S. Treasury bonds and gold bullion, is to short E.U. financials with PIIGS exposure. Those are banks with deteriorating fundamentals with share prices that are quoted in depreciating currency, which is going to 1 sooner or later. While providing specific short recommendations of banks with E.U.-exposure is beyond the purpose of this missive, enterprising minds will find plenty of ADRs of such banks listed on the NYSE.
Long BRIC stocks/Short E.U. financials is a strategy that will work well over time despite any short-term gyrations.
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