Emerging prudence about EEM Emerging Markets

Martin Hutchinson, who writes the "The Bear's Lair" column for PrudentBear.com his most recent (September 16 2006) column is The James Jesus Angleton economy. It is about Russia and dangers of an economy that runs for any purpose but enrichment.

Russia is said to be keen on inviting foreign capital into its electric power generators; an ambition that at first sight conflicts with its determination to keep control over its oil and gas sectors. However, this apparent confusion in economic doctrine is explained by the Russian government s overriding concern with security and power-political matters. What's not clear is whether an economy run in the interest of "National security" can work in the long run.

Mr. Hutchinson describes some of the motivations behind the Russian government’s meddling in the Russian economy. The Russian government seeks to operate the economy for the purpose of promoting Russian (i.e. Kremlin) influence, power and security. The Kremlin's interests are not always those of outside shareholders. Examples of intervention abound: the enforced liquidation/expropriation of the Yukos oil company, natural gas embargos on Ukraine, government attempts to cobble together a world class aluminum corporation. All this meddling and politics creates risk for investors who are not plugged into the Russian powerstructure. People tend to forget that.

Russia is not alone in having an economy susceptible to nationalist intervention. Each of the BRIC countries and many other emerging markets share this risk as well.

The non-democratic BRIC countries, (Russia and China) have a history of government intervention whenever the central government feels the economy is not operating "to spec". The democratic BRIC countries (India and Brazil) have left-nationalist political parties bouncing inside their democracies. Economic stress could lead to a Venezuela / Bolivia-style nationalist backlash in each the BRIC countries.

This economic paranoia driven political risk is unusual in developed markets. In developed countries political risk is predictable, constant, and not a factor in most investment decisions. It's easy for developing markets to have political blowups with substantial impact on share prices. Many people forget about that, because they aren't used to thinking about political risk.

ETFs make it simple to get exposure to emerging markets. The new BRIC40 ETF from Claymore/Bank of NY, will tap into investor interest in the prime emerging markets. The BRIC countries are expected to collectively overtake the US by mid 21st century. The extraordinary and unusual risks of emerging markets are an interaction of reflected US risk (given the tight linkage between export and import based economies) plus endogenous political/economic risk. This quote from Seth Klarman's 2005 Baupost Letter seems apt

When conditions are generally benign, with markets perhaps even shrugging off bad news, investors tend to forget just how much they can lose and are lulled into sleeping well when they should be tossing and turning. While the recent absence of calamity is not necessarily a sign of impending disaster, neither is it a reason to project only blue skies ahead. After all, financial disasters, like natural disasters, can strike without warning.

There is a diversification benefit from the unique risks of (EEM) investments. However what gets lost in the hustle is that the total risk of EEM investments is much higher than commonly thought. After adjusting for risk, are they still worth it? Probably not.