Sleeping with an Elephant- Emerging Markets-How Diversified are You?

In a terrific U.S. Equity Strategy piece from Citigroup's Tobias Levkovich, dated May 25th, he reminds us of some interesting connections that he sees among emerging markets, energy, and commodities.

The important observation that Tobias makes is that bets on many emerging economies have a sinister side...they are merely leveraged trades on the U.S. consumer. China and India may well develop their own consumer base over time, but for the next few years, success relies on exports to the U.S.

Pierre Trudeau, the late former prime minister of Canada observed that Canada's relations with the U.S. were like sleeping with an elephant..."no matter how friendly and even-tempered the beast, one is affected by every twitch and grunt."

Weakness in the U.S. consumer will be a twitch and grunt that will be amplified through these emerging economies and markets.

Weakness in the U.S. dollar won't do others any good either.

As Tobias observes, money flows into emerging markets have been astonishing...in fact, money flows into emerging markets funds as a percentage of total money flows, is four standard deviations above the average. If regression to the mean is something you believe in, and I do, the outflow will not be pretty, especially if the US consumer economy softens.

If commodities and basic materials markets are a derivative on global growth in the developing world, there may be negative impact felt here.

Think about the sectors that got killed this month...basic commodities, energy, and emerging markets. It may not be a coincidence. There appears to be considerable convergence and consequent correlation in the economic drivers for each of these sectors.

You may be less diversified than you think. Simply owning different names across different economies does not provide risk reduction. If your holdings correlate in the market, they may have common economic drivers.

Now that the term BRIC (Brazil, Russia, India and China) has entered the investment lexicon, think of the derived demand picture. Back in 2000-2002, media and Internet convergence killed many investors. Diversification by names alone provided false comfort. Most companies were rooting for exactly the same thing and there was a common driver to the stocks.


Don't let it happen to you again.