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Gloom and boom

Share prices of companies in the commodities industry and emerging markets have set a blistering pace in recent weeks. The likes of BHP have seen their share prices rise by over 50 per cent from their low point in mid-August while the shares of some companies that are both commodity producers and domiciled in emerging markets, such as CVRD of Brazil, have almost doubled in the same period. This has taken place against a background of deteriorating economic news in Western economies and plunging share prices in the property and financials sectors.

The long-term story for emerging markets such as China is powerfully positive but who is left to discover that? There comes a point when it is hard to reconcile a view of the world that simultaneously sees worsening gloom in the world’s biggest developed economies with uninterrupted boom times in the major emerging markets. How can recent movements in financial markets be explained?

One explanation is to consider events in the light of an observation made by Mark Twain who remarked: “History doesn’t repeat itself but it rhymes.”

The devaluation of the Thai baht in July 1997 acted as the catalyst to a general crisis in confidence towards Asian emerging markets and a period of economic hardship in many parts of the region. A year later, there was a Russian debt crisis and the US hedge fund LTCM failed. Western economies remained relatively unaffected through this period although the world’s leading central banks cut interest rates to bolster confidence. The resulting surge in liquidity undoubtedly helped ease problems in emerging markets but it laid the basis for the ensuing boom in Western equity markets and the creation of the TMT bubble.

Easing monetary policy is a blunt instrument. It does not just help the parts of the economy being targeted. Liquidity tends to flow where momentum is strongest and the short-term news flow is most positive. This sequence helps explain why the current credit crisis has boosted bull runs in commodities and emerging markets in a mirror image re-run of the events almost a decade ago.

The long-term case for investment remains valid in these areas but the upside versus downside risks are finely balanced. Valuations of emerging markets are no longer at bargain levels. For example, five years ago the price-earnings ratio of the Brazilian market was in single figures and around one-fifth of the level of the US market. The price-earnings ratios are now broadly comparable.

At the opposite end of the spectrum to emerging markets and commodities in these momentum-driven markets have been areas such as UK commercial property. This sector illustrates how quickly momentum can turn and there will not be a quick turn-round in the negative news flow dogging the sector. As ever, the investment trust sector has magnified the impact of the change in sentiment and shares in Chris Turner’s TR property investment trust have been trading at a 13 per cent discount to net asset value. This should be a good level to buy for the patient investor.

Buying into unpopular areas and selling out of investments enjoying a period of vertiginous ascent is nerve-racking. Having made seven times his money in four years, Warren Buffett recently sold his holding in PetroChina. He was abiding by one of his shrewd observations about investing, which is to be greedy when others are fearful and fearful when others are greedy.

Richard Scott manages the CF Iimia growth & income fund


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