Emerging Markets, Inflation, and ETFs: Q&A With Richard Kang

by on March 23, 2011 | ETFs Mentioned:

Richard Kang is the Chief Investment Officer and Director of Research at Emerging Global Advisors, LLC, the only ETF issuer to focus exclusively on products offering exposure to emerging markets.  He recently took time out of his busy schedule to talk about emerging market ETFs and inflation with ETF Database.

ETF Database (ETFdb): Inflation has become a hot issue in emerging markets and has been cited as a cause for some of the big dips we have seen this year. Is inflation a major concern, a small bump in the road, or somewhere in between?

Richard Kang (RK): It is a major concern. Investors have been talking about it for a while, and saying there’s a risk of hyperinflation. Personally, I’m more concerned with the general inflation trend.  From the 1970s, where you had very high long term rates, it went to a point where essentially over the last six or seven years, people have had “free” money, ultimately leading to a housing bubble and other economic problems. And now we agree that it is going the other way.  It’s just a matter of when.

The fact that there was such severe inflation and that policy in our generation has revolved around the need to control it with interest rates led us to where we are today.  Further, we have had a disinflationary world because cheap labor in China allowed that country, among others, to ship low-cost products into major retailers like Wal-Mart. That trend is also reversing, because those countries are now becoming wealthier, paying themselves a bit more relative to the western world, and allowing their people to maintain an increasing standard of living – all of which is inflationary.

If you look at the rise of the U.S., England, Japan and Continental Europe after WWII, as with the rise of any economy, you will see inflation. It’s just on a much larger scale now, and the greater concerns are tangible because of the sheer scale as a result of demographics.

If you have both rates going up and inflation slowly going up, and you have investors who believe in a traditional stock/bond/cash portfolio, the bond portion is in real trouble.  In addition to the inverse relationship of price and interest rates, increased inflation degrades the potential of “fixed income” returns.  This all makes intuitive sense but for our aging population with potentially greater weights biased to bonds, one must wonder if there’s trouble ahead here.  If so, investors need solutions.  When we hear someone like Bill Gross saying that he’s thinking more about stock exposure over bonds, I think investors should consider it as well.

ETFdb: Certainly inflation is a problem, but does it also create opportunities in the emerging world?

RK: It’s definitely a problem that you have to accept, and with the problem comes the opportunity to find the solution. It may be quantitative easing and the exporting of capital that is fuel for inflation in the emerging markets. In this carry trade, the borrowing of US dollars or Japanese Yen to invest in higher yielding areas of the emerging markets world can clearly result in inflation within their economies.  Even without it, the fact is that they have had strong growth and the resulting organic inflation.  X factors like weather patterns only exacerbate the situation:  the media highlights facts like an onion costs eight times more than it did several months ago in some emerging markets.

From an investment perspective, that kind of problem leads to a practical solution. Investors can apply very basic strategies, such as sector rotation, to address this problem. Take the S&P 500 for example. We are now at the baby boomer age, and the broad implication is that Americans are going to be spending less. That does not (or should not) mean you start to exit, or even short the S&P 500.  Perhaps a more reasonable approach would simply bias towards sectors such as health care and financial services – the products and services better tailored to an aging economy. Similarly, in the emerging world, you do not just simply exit out of the emerging markets; you need the growth and yield that come from these allocations. Instead, you bias towards inflation-sensitive areas like energy and materials. And let’s not overlook consumer staples as a sector.  This large population still needs to consume products like food and fuel to meet basic needs.

ETFdb: Sticking with the emerging markets, we hear people talking about the long term outlook using the term “favorable demographic trends” a lot. What exactly does that mean, and how does that translate, over the long term, into the economic potential?

RK: We know from recent history that countries that have been devastated by manmade or natural disasters are able to recover. As long as they had a population of a good size, and they had education, they are able to go beyond being what I call a frontier market, which is essentially defined as an economy that only relies on stuff from the ground:  agriculture, metals, oil.

So Dubai, for example, imports people to help build its skyscrapers and ski slopes inside of buildings.  If you have an educated population, like Japan and Germany, instead of building basics, they progress to build cars, technology, and other important products.

So where is the potential now with demographics?  I would say China and India are the big ones, though Brazil and Indonesia are both close behind. All have an educated population albeit some better than others.

But the numbers are simply staggering. We know that in our population of some 300 million people, there are approximately 75 million baby boomers nearing retirement. Of the 1.3 billion in China roughly 750 million – ten times our boomer population – live in rural parts of the country.  They are relatively poor, not like the coastal China that we know with the gleaming glass buildings. And they are also the country’s future consumers, having yet to spend like others closer to the coast.

But they need infrastructure to do so.  If there is an earthquake in parts or rural China, emergency services can’t easily get to them; there are no extensive road networks and limitations in terms of large scale airports. Fortunately for them, there are plans to have a better infrastructure system, which will bring greater commerce to their region and as a result will allow them to better consume.  In short, for rural China to obtain what the modern part of China has is in the best interest of the entire country and its one party system.

When you compare what’s happening in China to what we’re seeing in India and the latter’s far greater need for modern infrastructure, we know that this is a very long term development.  In fact, we believe that this modernization process is on a much larger scale than anything we’ve seen in the U.S.

ETFdb: What about achieving exposure to emerging markets through large cap U.S. equities that generate a big portion of their revenues from developing economies. Is a fund like SPY a play on the emerging markets?

RK: While there is some logic to that, it is definitely not a black and white issue. If the Russell 2000 or U.S. small caps overall did better last year, it was because investors thought that growth within the U.S., the real recovery from our own consumption, was going to happen.

With regard to the emerging markets the question is, are they going to rise or fall with the U.S. or is there real decoupling happening? It is unclear. What we do know is that there are pure play emerging market companies, which are local companies favored by the emerging market consumer.  They are better positioned for success there because of brand recognition and more efficient cost structures.

An Apple iPad is a luxury item in an emerging market economy. Even though we think of Taiwan and China as low cost labor, to them it is high cost labor.  The wages earned by the actual maker of an iPad component are not inexpensive to them.  Cost matters.  Take a European name like Swatch or an American name like Nike; these are of course popular brands in developed markets that people in the emerging markets are also going to want.  But more often than not, they won’t buy the Swatch or Nike-brand product.  They are actually going to buy the local equivalent because of cost.

Furthermore, if we agree that the current inflation situation is bad in the emerging world, and especially the non-core fuel and food measures, then it stands to reason that it is wiser, from an investment point of view, to focus on a local food company or an energy company or a material company in the emerging market that provides products that are absolutely vital.  People can hold off on buying a Swiss watch or American sneakers, but spending on staples is going to continue.

ETFdb: There is not a single definition of an emerging market. There have been some thoughts that South Korea is on the path to developed market status, while others would say that it is already there. What is your firm’s methodology for determining what is an emerging market and what isn’t?

RK: Emerging Global Advisors uses the same method used by the IMF, which focuses on GDP per capita. I think for most investors, they do not really make a decision of emerging markets or developed markets based on GDP per capita. The real driver for investment choice is based on objective, and if your objective is growth, most people are now calling emerging markets “growth markets.”  Rightly so.

Korea is less of a growth market than it has been in the past, and the same goes for Taiwan and Israel. And that is partially because domestic consumption is not the same as during the 80s and 90s, when they truly were emerging markets.  It’s not like they’re stagnant.  But it’s the decelerating trend of growth that matters.  We’ve seen this before in Japan.  They bought what they needed, whereas the relatively poor, those who have been generally savers in the true emerging markets, are now spending more.  Perhaps not a lot per person, but in size, it is.

Thus, this demographic tailwind is very important. We can look to the more aged, slightly more developed countries for patterns of what to expect in emerging markets.  Central and Eastern Europe as well as Russia fit this description; families there are not having “enough” children.  A younger population means a broader consumer base; older populations consume, but they do not add to productivity.  Many countries that have “emerged” show families having fewer children so they can enjoy a higher standard of living.

And it is exactly what has happened in Japan.  You could not photocopy an economic plan any better … Korea and Taiwan definitely are the Japan of the future. It is hard to make such strong black and white comments, but they will have the same problems as Japan, because they are not having enough kids, the growth story is over and they are pushing jobs outside to cheaper labor in the Philippines, Thailand, and mainland China.

ETFdb: As people take a closer look under the hood of their emerging market exposure, they see that there are heavy tilts towards generally banks and energy companies. What value is there to getting more balanced exposure? What might some of these larger, mega-cap weighted funds, be missing out on?

RK: If you look at a typical index fund, it is going to be market cap weighted, which is the most common and least expensive way to index. In the emerging markets there are so many large energy and material names that these companies will necessarily account for big portions of market cap-weighted indexes and the ETFs linked to them.

We know that there is more innovation coming out of the emerging markets, so looking at technology exposure is important. The consumer sector can also be overlooked by cap-weighted products, but is backed by a very compelling investment thesis. We are in a time now where investors have to think very carefully of how they have been behaving with their views on emerging markets. The data showed in 2010 there was a big move to risky assets, especially emerging markets. It was really a break-through year for emerging markets. The first two months of 2011 has been simply the emerging market take back. Investors have been taking their money out, and the net outflows have been huge.

With the broad emerging funds that everyone knows like EEM and VWO, there is only so much you can do. You can either buy-and-hold or you can market time. There is not much beyond that. So if you want to make a more targeted play based on views on inflation or consumption or infrastructure, you have to add bias. And the only way to do that is to prefer one country over another or one sector over another or perhaps some other factor. Emerging Global Advisors and other ETF providers that focus on emerging markets are providing tools so investors can obtain that more precise exposure.

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Disclosure: No positions at time of writing.