THE BIG SHIFT
by Yiannis G. Mostrous
Editor, Growth Engines
August 2, 2007

From the start of 2007, my two main premises have been that the markets would be higher by the end of the year and that volatility would rise, so you should expect corrections--sometimes big ones. I'm two-for-two so far.

As everyone is aware by now, global markets are currently trying to price the problems emanating from the US subprime mortgage market into their valuations. As I wrote four to five months ago in The Silk Road Investor, everyone knows that the housing sector in the US is rapidly weakening and, most important, that the lending practices during the past four years have created some kind of credit bubble that's waiting to deflate.

But because of the endless financial engineering that's taken place--through the securitization of loans, for example--no one knows who holds what, what the real credit rating in these instruments is (where different kind of loans have been packaged and repackaged into collateralized debt obligations) and what the actual size of the various markets involved in the securitization scheme might be.

Consequently, the assumption being made by the majority of market participants is that the risk has been spread around. Therefore, any potential adjustment won’t be as painful as before. But given the lack of real knowledge regarding the situation, this remains more or less a speculation no matter how truthful it may be.

Nothing has really changed. Although the market is trying to assess the situation, the majority of the market participants are still in the dark regarding the details involved in the matter.

It's naive to equate volatility with a bear market as a lot of market observers often do. What volatility means is you'll need to bolster dynamic companies with large cap, high-quality investments and defensive sectors.

Asia on Top

The Asian financial crisis 10 years ago turned out to be a blessing for its economies. Every aspect of the region's financial apparatus was re-evaluated and restructured. And the region now has strong foreign exchange reserves, high household savings, little debt on most sovereign and corporate balance sheets, better governance and solid growth fundamentals.

Furthermore, the best quality of the region now is the absence of leverage and crazy derivative instruments. Even its corporate debt market is very small. As a result, Asia is a powerful investment story that's playing out slowly but steadily, even if it sometimes runs ahead of itself.

The global markets will be affected as investors try to sell what they can and not what they should. Consequently, although economies around the world will suffer less from the US woes than they have in the past, their markets will be hit; short-term caution is required.

But, longer term, investors should be able to realize the big change that continues to unfold in front of our eyes. Demographic, cultural, social and economic forces in Asia position the region as an important driver of global growth. A tectonic shift is taking place in the world’s economic foundation. And farsighted, open-minded investors will benefit the most.

There will be bumps along the way; linearity isn’t a characteristic of emerging economies. Investors who choose to ignore this reality will end up much less better off.

Generalization and oversimplification won’t be helpful either. For example, one idea that's been floating about for sometime now is that the combined populations of India and China amount to 2.3 billion new consumers. Although there’s a long-term case to be made regarding the rise of a new middle class in the region (see my book The Silk Road To Riches: How You Can Profit By Investing In Asia's Newfound Prosperity), the situation is more complicated than adding up all the people and making sales projections based on them lining up to buy all the goodies multinational corporations can sell.

This is just one Asian shortcut Western investors have carved during the centuries. For an excellent account of the disasters--all of which stem from the fact that the West has always viewed itself as superior to the East--that have flowed from such naïvete, I highly recommend Carl Crow’s timeless classic Four Hundred Million Customers: The Experiences--Some Happy, Some Sad--of an American in China and What They Taught Him (Harper & Brothers, 1937). First published in 1937, it remains today as fresh and valuable as it was then.

Consequently, expect Asian economies to come out of any slowdown much stronger than before and their markets to outperform their more-developed counterparts again after the correction--deep or otherwise--is over.

© 2007 Yiannis G. Mostrous
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