This is the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with emerging-market specialist Jerome Booth from Ashmore Group
EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with Jerome Booth.
David Kuo: This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and my guest today is someone who is as comfortable reading a music sheet as he is reading a balance sheet. He plays the double bass, sings in a choral society, but is perhaps better known for being one of the founders, and the very public face, of Ashmore Investment Management Limited. He is Jerome Booth, he is an emerging-markets specialist, and he is with me now, so welcome to The Motley Fool, Jerome.
Jerome Booth: Hello.
David: Hello, well I've been dying to get you in ever since we met each other on the BBC World Service, talking about emerging markets. I want to start in the West, and I want to know what you think are the likely implications of quantitative easing on the U.S., and also Europe?
Jerome: We have an enormous deleveraging ahead of us. We have to compare the scale of the debt that has been built up over three decades with the 1930s, but compared to the 1930s, we have two things which we didn't have then. One, Keynes invented macroeconomics, so we ought to know what we're doing, in terms of policy; and secondly, we have the emerging markets as a potential source of global aggregate demand. But your question refers to the first thing: quantitative easing is there to prevent a depression. I don't think it's necessarily going to create stimulus, it doesn't create animal spirits. It doesn't necessarily lead to domestic investment, but it prevents banks imploding. But it does have a consequence, that we're having an enormous increase in the money supply, of certain types anyway, and this is having an effect globally. There are a lot of emerging markets who are complaining about this, but actually, this is an inevitable consequence of the imbalance -- a long answer to a simple question, and very true. It is unsustainable; it is not going to be the case that China is going to buy another two trillion of U.S. Treasuries -- it's just not going to happen. At some point, we have to have a reversal. So, what's this got to do with quantitative easing? Well, quantitative easing is, if you like, the method to save the banks that is happening in the U.K. and Europe and the U.S., basically printing loads of money. Eventually, this pressure, if you like, on emerging markets, there's this pressure to adjust their exchange rates upwards. They're feeling this pressure with quantitative easing. They're facing the Western economies trying to flood them with money, and they're becoming less competitive.
David: But isn't the point, Jerome, that as far as quantitative easing is concerned, it was designed, as you say, to try and save the banks here in Europe? But the consequence of that is that cash is a very liquid asset, it can go anywhere it wants to. I recently read stories in Singapore and Hong Kong, where they're saying, my goodness -- this hot money is turning up on our doorstep, it's turning up on our shores. It's pushing up prices, property prices in Singapore. It's also pushing up the Hong Kong dollar, so much so that they have to sell the Hong Kong dollar in order to try and keep it down. So I mean, it's got some huge implications for emerging markets in the east.
Jerome: I don't disagree with you, but I would add two points. One, a lot of the so-called currency wars are really south-south, and that is that the central bankers are macro-economically trained, very intelligent, and they are fully aware of the history of the 1930s. I think they're very aware of the pressures, and they know that they can't intervene to stop where their currencies are going against what I call the HIDC currencies -- HIDC stands for Heavily Indebted Developed Countries. They can't stop their currencies going up against the euro, the sterling and the dollar, but what they can do, and what they want to do, is to stop their currency going up six months before the Korean won, or other Asian competitors. So what they really care about, particularly in Asia, is their exchange rates with other Asian economies, so they're all watching each other, and that's actually, in a way, a good thing, because when the Chinese in particular, who's the one that they're all watching most of all, starts to appreciate, then they can all appreciate at the same rate, but they're all going to be going up against sterling and the dollar, etc. I think yes, there's a lot of complaints about currency wars, but actually reality is that they are having to shift the focus of their economies, and they are doing that. We have seen a massive increase in south-south trade, particularly in Asia, and investment flows, and reserve holdings, and in addition to that, they've started to move, in some of the more export-oriented economies, toward more of a domestic, demand-led model of growth. So it is true that they have this pressure.
David: So as an emerging-market specialist, and I presume you're an emerging market-phile, in the sense that you quite like the emerging markets, what is the attraction of emerging markets for investors, then?
Jerome: Well, traditionally people think of emerging markets as somewhere you'd go for extra return, for a bit of extra risk. I think of it as somewhere fundamentally safer than the crash zone. I personally have about, if you count Ashmore shares, about 95% of my personal wealth in emerging markets, and that's because I am a macro-economist. I am actually very prudent, which means actually most of it is not equities -- it's fixed income, it's bonds, it's cash, and I'm awake, by which I mean, I join those two things together. I think investors need to start thinking about the world that we live in in a more realistic sense, associating emerging markets to some sort of tiny corner. It's not a tiny corner. The global equity markets are about 40-50 trillion dollars. Well, at the current rate of growth, just the fixed income markets in emerging markets will be the same sort of size. Already there are about 12 trillion, out of a global fixed income of 80 trillion.
David: So are you saying that it is less risky to invest in Indonesia than it is to invest in, say, Germany?
Jerome: I'm not sure about Germany, but France, yes -- I would say that. It depends what you are looking for, and where your liabilities are, because here's another thing -- there's been a huge set of problems with finance theory. We've got a lot of misconcepts, if you like, wrong concepts in our head. Risk is not a simple thing, and your risk is very different to my risk, because we have different liabilities. If I'm Indonesian, buying Indonesian bonds is clearly safer than buying French debt or German debt. We also have different information sets. If we both buy the same instrument, and it's a liquid instrument, but I get information about what's going to happen, unpleasant things, a day before you do, and I can get out, then I'm fundamentally not taking the same risk. So risk is being seen as a very simplistic thing, and it's not. It's also certainly not just volatility. The risk we care about most is the large, permanent loss, and if we want to be vivid about this, think of someone blindfolded, standing on a railway track, and they can think that there's very little volatility. They've maybe even got a consultant or an advisor, someone who's very bright, and they've got a special device to measure air volatility, and there's a slight north-west breeze, and it's modulating at a certain rate. When the train hits them, they experience quite a lot of volatility all at once, and the fact that all their peers are standing on the railway track with them actually isn't much comfort, because the train will plough through the lot, and it's those sort of risks that I'm thinking about here. As a macro-economist, what really matters is the sense of history, that global imbalances are fundamentally important. To say that, oh yes, this market in emerging equities in this country fell 60 something percent -- so what? The point is, all markets do that -- the U.S. equity market, the U.K. equity market, have done that in the 1930s, and we are in a very dangerous situation, and we have myopic policy-making which is behind the curve, particularly in Europe. We have, in emerging markets, very very diverse countries. The emerging markets are anything but homogenous. The first line of Anna Karenina, of course, Tolstoy's great book, says that all happy families are happy in the same way; unhappy families are unhappy in different ways, and I rather think of the process of development in emerging markets as similar to that. They're all actually massively different. The only thing that historically linked them together was the fact that, if you cut them off from capital for long enough, they all default, and they had that commonality. Fifteen years ago, the emerging debt market certainly had a very leveraged sort of hedge fund and bank-type investor base, that tended to go after one country after another, in a sort of contagion effect. That caused this sort of commonality of behaviour, that if one goes, they might all go, and that's all changed; why? Because the investor base is much -
David: Has it changed?
Jerome: It has very much changed. Emerging market debt is predominantly owned by long only pension funds. 40% of our assets at Ashmore is central banks and sovereign wealth funds, and a large part of the rest is pension funds and insurance companies. They are not interested in micro-trading this stuff. Hedge funds have had almost no impact on emerging market debt markets now since the early Noughties -- they are really not significant.
David: But does part of that attraction of the emerging market debt come from the fact that they are very high-yielding right now? Is that the attraction? They are yielding more than European debts?
Jerome: Yeah, if you look at European sovereign debt, it's either basically no return, in real terms. If you buy gilts today, and everything goes right, then in real terms, i.e., adjusted for inflation, you will lose money -- that's the best scenario. Now, we know from behavioral finance, apparently people don't mind being robbed slowly, but it's hardly rational. It's not actually a good investment choice, in my view -- it's just my opinion, of course, and I may be biased. But, on the other hand, you've got pretty high-yielding sovereign debt, higher yielding than in emerging markets in some cases, but there's a very good reason, because they are not necessarily going to pay you back in real terms the full value. When I say, in real terms, I'm saying, rich countries, you see, default by other means. They do it through robbing their pensioners -- we're going to see plenty of that coming. We're also going to see, which is relevant for foreign investors, devaluation and inflation. These are the real enemies for us as investors, in terms of the developed world fixed income. It's very, very seductive; it's very, very appealing for a policy-maker, the end of the period of deflationary management, to just keep the very, very low interest rates there, keep the quantitative easing for a bit longer, and just have close to double-digit inflation for five years, and that'll wipe off a lot of the debt. I think there's a very clear sense of financial repression, and I should probably explain that term. Financial repression is any policy which captures domestic savings, so from pension funds, insurance companies -- whatever, largely through regulation, but any policy that captures those domestic savings in order to fund the government, and to do at a lower cost than the government would otherwise have to pay. This was used very successfully after the Second World War in Europe. We had much worse conditions then, frankly. It's been used occasionally in emerging markets (one of the reasons I know about it), and as a taxpayer, one has to say, well, if they can't adjust politically, maybe that's acceptable. But as a saver, with money in a pension fund, I'm outraged, because I'm being robbed, quite deliberately. I'm being robbed because my pension fund is regulated, it's being forced to buy high-risk paper, i.e., European sovereign debt, and I'm not getting paid for it, because the yield is virtually nothing, and, because that's distorted the price, other investors who have a free will have stopped buying that, and so the investor base has become more and more homogenous, and that's dangerous. It actually creates systemic risk. So we're in a world where you've got this sort of sleight of hand, where authorities are trying to finance themselves, and talking very prudently or conservatively about low risk.
David: But as a fixed-income investor, you and I differ very sharply on this, and I'm glad we're both in the same studio, because you want return of capital -- I want return on capital. I put this to you, Jerome: if I invested in a company like Jardine Cycle & Carriage, a very well-known Jardine affiliate in Singapore, I would have had a total return of 34% a year, every year for the last 10 years. That is a phenomenal return for an equity investor. Other companies like Keppel, Keppel Corporation, which is a marine company based in Singapore also; another one is Singapore Stock Exchange, SGX -- that has returned 15% a year, every year. So why would investors want to go for fixed income, when they can go for capital appreciation with dividends, total returns, in excess of 15%?
Jerome: I don't actually disagree with you. They should do both, is the answer, but the point is, if you are an investor, and you do anything apart from equities, if you have the risk appetite for equities, you should do emerging equities, because the growth is there, the value is there -- the value is extraordinary, in emerging market equities right now. But if you also, like me, have a conservative side to you, and want to preserve capital, you might want to think about doing fixed income. If you do fixed income, you should do emerging markets fixed income, before you do gilts -- that's my point.
David: But you're introducing another risk, though, aren't you? You're introducing currency risk there?
Jerome: No, I'm actually reducing currency risk, because it's the sterling that's going to go down. So I could say that it's sterling that has a greater currency risk than the Indonesian rupiah. Now, of course, if we're talking to a U.K. audience, they may say, ah -- but my liabilities are in sterling, but are they? This is the interesting point, because what we really care about as savers is our purchasing power in 20 years. If we go through a period of high inflation, as we did in the Seventies, and your pension pays you 1,000 pounds a month, or whatever it is, in 20 years, and they say, that was what we owed you, and here we are -- there's your 1,000 pounds a month, and you then discover that 1,000 pounds buys a Bic biro, and that's it, you're not going to be too pleased with the pension fund, and they're going to say, ah -- we met your liabilities, and it's perfectly matched, and you're going to say, but hang on -- what about purchasing power? I'm saying, very specifically, that getting out of sterling is reducing your currency risk, which is controversial, it's heterodox, but it's a very different way of thinking about what our risk is.
David: But that's only today, though, Jerome, because I mean, what is to stop these emerging markets from devaluing their currencies? My point is that these countries need to export, and they cannot export if their currency gets more and more expensive, relative to the consumers in the West?
Jerome: Well, you see, I do differ here, because the way I see it, you've got some countries, the HIDCs, the heavily indebted developed countries, where on average the private plus public sector debt to GDP at ratio is 250%. In the U.K., it's 500%. This is massive indebtedness. The average for emerging markets is about 25%, and actually they're net creditors -- these are the net savers. So, the basic point is, they don't need to inflate; they don't need to export even to us, by the way. We need to export to them, and they already, by the way, are getting much more focused about each other and their own domestic markets. It's not just about exports any more. But the key issue is, if you've got this amount of debt, think about the U.K. -- what are policy-makers going to do? Be they Labor or Conservative or Coalition, it doesn't matter. We either face 20 years of creating fiscal surpluses, and that's hard work -- that's politically very, very tough. That means cuts for years and years and years, and we're talking about 20 years -- we're not talking about five years ... or, you have a bit of inflation, a bit of devaluation. So the motive for devaluation, you can say, oh -- well every country in the world has a motive for their export lobby to devalue, but there are also other motives. The point is, no -- you can't everybody devalue, right? At the end of the day, there are countervailing forces, and the point is, the motive for devaluation is much stronger in those countries with really high levels of debt, and that's actually us in the West, not the emerging markets.
David: That's interesting, because I would have thought that the reason for devaluation would be in order for those countries to export, and to regenerate growth. It's almost like the whole world is, at the moment, dancing on the head of a pin, and that pin is China, because everybody is watching China very carefully. Recently, Burberry
Jerome: All true, but I would say it's partial, because actually China is a closed economy. We get a huge amount of information about China's exports, but actually there's an enormous car industry in China, for example. They're all sold domestically. China is really about domestic growth, and their export industry has been a great driver for their growth over the last few decades. That's coming to an end -- they're going to reduce that dependency. They're making huge inroads in moving toward greater consumption domestically. This is a trend across emerging markets. So what you say is not wrong -- Burberry's having problems. There will be more and more problems for Western companies exporting to companies that are moving more to an inward direction.
David: Mulberry was another one. Mulberry came out just a couple of days ago, and they said, oh, we can't sell our handbags, and it's primarily because the Chinese aren't buying them.
Jerome: Yes. My point is, these are very interesting individual company stories. The bigger picture is, I think, the larger focus of global imbalances, the shift of economic policy toward domestic growth, and trade with each other, but it's not just about their export market. Yes, they're slowing, but they're slowing to 7.5% growth. But anyway, the bigger picture is that these economies are moving away from dependence, particularly China, dependence on exports. The other big thing, I think, which maybe I'll bring in at this point is, this idea of core periphery disease. I've got this theory, and I call it a disease, because it's a very entrenched idea. It's a meme -- a meme is a sort of intellectual virus (Richard Dawkins came up with the idea). It has self-replicatory qualities, just as genes do. A meme could be a tune that you can't get out of your head.
David: I have one, it's called the Mah Na Mah Na song, by the Muppets.
Jerome: Yes, well, there you go.
David: I can't hum it here, because everybody will be humming the Mah Na Mah Na song.
Jerome: Well, it could be that, or it could be some economic theory, but my meme, if you like, that I want to flag here, is what I call core periphery disease. This is the idea that the West, Europe and the United States, is the core, and much more important than anything else. The core affects the periphery, the emerging markets, but we can ignore the effect of the periphery on the core. This, for example, is expressed -- there was an IMF study a few months ago, asking the question, how much money might leave the emerging markets, if there's another financial crisis in Europe? And the answer is, well, 38 billion. It sounds a lot, but is it? This is an illustration of core periphery disease, in the sense that they didn't ask the question the other way round, and once you do, you realize that the emerging markets, central banks and sovereign wealth funds, own 11 trillion dollars of European and U.S. sovereign bonds, so things they could sell quite quickly, and that's two orders of magnitude more than the flow that might go the other way, so these are the big creditor countries. What happens to them is under their control. When you have those reserves, when you have those net savings, you can actually drive your economic policy. They have the policy tools. Another form of core periphery disease is this idea that, and this combines with the sort of linear idea of risk we discussed earlier, that people have this tendency, and this is part brain and part gut; if they get risk-averse, then they've got to sell their "risky assets," and emerging markets is clearly a risky asset, so they sell their risky asset, which is equivalent to saying, well, if I've got a problem at home, what do I do? I stay at home. It doesn't make much sense. If you think through a scenario here, say we get the worst possible outcome in Europe, and that means depression a la 1930s.
David: We're not going to get that, are we?
Jerome: Hopefully not, no, but if investment collapses, it's definitely possible still. It is a possibility.
David: You're one of these doom-mongers I keep on hearing about.
Jerome: No, I think it's a scenario. I'm a macro-economist, and actually, among macro-economists, this is consensus. This is what Keynes taught us. But say that happens, in the 1930s, when this happened, in the U.S., net investment fell 95% -- that's what drives employment, so unemployment went from 3 to 25%; 50% in urban areas. Growth didn't recover until 1941, at which point 50% of GDP was public sector, because, oh -- we had a war, and equities didn't recover until 1954. That's a fairly unpleasant scenario, OK? So in this scenario, if we have that again, or anything approaching it, and I'm not saying it's going to happen, but it is a possibility, then clearly you're going to get negative growth in Europe and the U.S. It's also very definitely going to affect the emerging markets. In fact, it's so bad that their average growth rate might go all the way down to 4.5% -- it's that bad, folks. But the point is, whereas the logic of that scenario is that, if you're risk-averse, you should very definitely have all your money in emerging markets. The gut reaction is to think, oh -- they're risky, so therefore I've got to put all my money right back in the crash zone. So, we have this core periphery disease, which affects the whole way we look at the globe. We also seem to think that emerging markets is somehow a small bit of a portfolio, or a small sort of add-on, and we touched on earlier that it's only seen as the sort of high-risk bit.
That was the first part of a two-part transcript in which Fool.co.uk's David Kuo chats with emerging market specialist Jerome Booth from Ashmore Group. They look at quantitative easing from the perspective of consumers in emerging markets and also from the perspective of financial repression in the West. They consider whether there is any truth in the assertion that the creation of fresh money in the West is ending up as hot money in emerging market assets. They also look at whether emerging markets are inherently risky.
In the second part of the transcript, Jerome discusses how much exposure to emerging markets investors should have. Just click here to continue reading.
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David owns shares in Burberry. The Motley Fool has recommended shares in Burberry. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
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