U.S. Global's Derrick Sorts Through Emerging Markets: Weekend Interview

Some emerging markets could outperform more developed ones due to higher commodity prices, a weak U.S. dollar and other factors

To gauge the various factors influencing international markets today and where the best investing opportunities are, AdvisorOne spoke with John Derrick, director of research for U.S. Global Investors.

What are the most important global-investing themes or issues today for you and your organization?

Derrick: The most striking global theme today is inflation, especially in emerging markets but not necessarily limited to emerging markets. As a result, we are seeing central bankers and policymakers worldwide make adjustments -- China, India, Brazil and other nations have been raising interest rates to combat this, and we’ve also seen the European Central Bank raise rates, too. This leaves the United States as the sole major player with a loose, very accommodative monetary policy.

Going forward, if policymakers can get inflation under control or become comfortable with where inflation is, then some of the associated trends might reverse themselves. In China, for instance, by the end of the second quarter, the government may be done with its short-term tightening measures. There could be a light at the end of the tunnel on inflation, even within the next few months. This would allow the equity markets and investors to become more comfortable with this situation.

Another theme to watch is the quantitative easing, or QE, program of the U.S. Federal Reserve. Ben Bernanke said recently that the Fed continues to plan on this program through the end of June and won’t shrink the balance sheet, though it may tweak some holdings and swap one bond for another. More or less, we are seeing more of the same from the Fed. With that, we saw Treasuries rally and have seen the U.S. dollar sell off.

Thus, another big theme this year is the weak U.S. dollar, which ties into some of the things that I just mentioned. We are an outlier from a monetary-policy perspective, and that makes the United States less attractive and other countries more attractive. Plus, the GDP growth figure came in recently at 1.8 percent, which is pretty lackluster; unemployment is still high; the Fed is still struggling to kick-start the economy, so we have the QE program.

There is some concern that the Fed will have to implement a QE3, maybe not immediately after QE2 but perhaps sometime before the end of the year, since economic growth and job creation are most likely going to remain week. Fiscal tightening and austerity issues are emerging, so there is now a call to consider the consequences of public spending. But this will put more pressure on the Fed; if the fiscal side is acting as a drag on the economy, the Fed could move to counteract that.

What positive investment opportunities do you see based on the trends you described earlier?

Derrick: A weak U.S. dollar likely implies higher commodity prices – oil, gold, copper, etc. For global investors, it’s likely that the continued fall in the U.S. dollar will go hand in hand with the appreciation of foreign currencies, particularly in emerging markets. China, Brazil and others are going to benefit from this situation.

Another issue to consider is the fact that the emerging markets have been fighting inflation for a while now; the United States hasn’t even started to do this. There is a potential that when the tightening in these markets stops, the markets get somewhat more comfortable with inflation and then rally.

These markets haven’t moved too much this year, though they’ve been in line with the United States – say 5 percent vs. 8 percent for the S&P 500 year to date. And this situation could reverse itself. There is some uncertainty surrounding the U.S. markets, since we don’t know what the Fed and policymakers in Washington D.C., are going to do.  The U.S. markets have outperformed the emerging markets so far this year, but maybe there could be a different story in the second half of the year.

A lot of risk has already been priced into the emerging markets. Also, let’s keep in mind that support for higher commodity prices overall is good for emerging markets, excluding China, India and Turkey. The emerging economies tend to be exporters of commodities.

The commodities story supports economies like Russia, where higher oil prices are a real benefit to the economy with the whole trickle-down process that takes place; whereas in the United States, higher commodity prices have just the opposite effect.

For the second half of the year, you can see how the emerging markets could outperform the developed markets around the world and different factors come into play – like QE2, peripheral issues in Europe and how they get resolved, etc. The emerging- or developing-markets story does require that these countries keep inflation under control and stop tightening, which the markets should respond favorably to. 

What about other areas of potential opportunities and/or risks?  

Derrick: There are some other themes that should play out well for investors in the long term – such as infrastructure development. Other areas that we see benefitting on a long-term basis include global energy and natural resources. And another theme is the emerging consumer, which I still like. Yes, higher energy prices impact consumer spending in emerging markets, but this is more than offset by wage increases and better jobs, as well as broader trends such as urbanization and industrialization.

By extension, emerging-market retailers or those selling food and health-care products and services in these markets stand to do well – especially those offering western-style products and services. 

Some of the U.S. industries that stand to benefit are technology, health care and manufacturing. A weaker dollar makes the United States more competitively internationally. If you are General Electric and you are competing with [German-based] Siemens, then your products might be 10% cheaper vs. what they were a few months ago. This represents a global competitive advantage at least in the near term, and we think a weaker dollar could give a boost to U.S. manufacturing, technology and other sectors that sell a large component of their products outside the country. 

For the United States, when the Fed decides to do something different, we could see a shift in U.S. dollar weakness. But we don’t expect this to be the case in 2011, at least.

Would you like to comment on other global dynamics affecting international investing at this time?

Derrick: In Japan, obviously, the disasters there – earthquake, tsunami and nuclear-reactor problems – are having a bigger impact on the economy than was first thought. The ramifications are getting worse, with auto production not looking like it could be back to normal until November. Japan is in a  difficult situation, with talk about energy being rationed. It’s hard to say when or how things will change.

In Europe, you still have peripheral economies with problematic situations. Greek two-year bond yields have gone to over 20 percent, and 10-year bonds are at over 15 percent. There are discussions about debt restructuring, even though the need for it is being denied by some authorities. But at a certain point, it becomes self-fulfilling. How can you cover these bond rates? It just compounds the problem.

Thus, some debt restructuring in Greece could have a negative impact, particularly on some European banks that hold that debt – they’re having to take write-downs on that, representing a negative overhang on the markets. Lately in Europe, it seems as though it’s been a cycle: As soon as you get one problem “resolved,” then the market focuses on the next one. After issues in Portugal were resolved, for instance, then focus turns to Greece.

What would be next? I am not sure, but there are lots of issues there with negative ramifications, particularly for financial institutions and perhaps for the economy overall. Restructuring, IMF involvement, its terms and conditions are onerous, such as higher taxes, pay cuts, etc., and can make it difficult for economies to grow -- meaning the affected economy grows slowly or has to contract. Overall, there is a fair amount of uncertainty in Europe for the second half of the year.

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