Emerging economies can be divided between the sheep and the goats. Photographer: Tomohiro Ohsumi/Bloomberg
Emerging economies can be divided between the sheep and the goats. Photographer: Tomohiro Ohsumi/Bloomberg

(This is the first in a two-part series.)

Since the start of 2014, investors have fretted over emerging markets. And they should. Early in this economic recovery, investors repelled by low returns in the developed world leaped for the stocks and bonds of emerging markets, whose markets promised faster growth.

In 2009 and 2010, emerging economies grew much faster than the U.S. did; stock prices rose 46 percent annually, more than twice the gains of U.S. equities. Hot money flowed in, but so did foreign direct investment, which is harder to extract. Last year, foreign direct investment in the developing world grew 6 percent, to a record $759 billion, or 52 percent of the global total.

In their indiscriminate rush into emerging markets, though, investors forgot two important points: First, without exception, these economies depend primarily on exports for growth, which means the developed economies, especially the U.S., must be capable of buying their goods. And second, not all emerging markets are alike.

Financial Contagion

On the first point, the developing world's export growth model, which worked well in the 1980s and '90s, won't be viable for four more years or so while the U.S. continues to deleverage. Europe, meanwhile, has emerged from recession, but its economic growth will probably remain subdued at best.

The decline in the U.S. household saving rate from 12 percent in the early 1980s to 2 percent in the mid-2000s drove growth in the U.S. and the global economy. During the savings drought, consumer spending grew one-half percentage point a year faster than disposable (after-tax) income and added about half a percentage point to growth in real gross domestic product.

Now all that is moving in reverse: Households are pushed to save by uncertainty over stock portfolios, exhausted home equity and the lack of retirement assets held by postwar babies.

The overseas effects of this reversal are powerful. For every one percentage point rise in U.S. consumer spending, American imports -- the rest of the world’s exports -- have risen 2.9 percentage points a year, on average. So when Americans stop spending, the rest of the world suffers.

On the second point, investors who rushed into emerging markets and failed to differentiate among them are now feeling the pain of that mistake. Emerging economies can be divided between sheep -- developing countries such as South Korea, Malaysia, Taiwan and the Philippines with well-managed economies as measured by current account surpluses, low inflation, and stable currencies, stock markets and interest rates -- and goats, with current account deficits, weak currencies, high inflation, falling equity prices and rising interest rates.

The goats don’t have the funds to cover the outflows of hot money that began last spring. Consequently, goats such as Turkey, India, South Africa, Indonesia, Argentina and Brazil have been forced to raise interest rates to attract and retain foreign funds. The goats have other problems, including labor unrest in South Africa, which forced the government to raise wages during the economic slowdown. Turkey and India have major problems with government corruption.

What's more, tremendous overspending on subsidies in Argentina and Venezuela have caused inflation rates and current account deficits to balloon. The results are currency controls, domestic shortages and currencies that are hugely overvalued when compared with black-market rates -- even after the recent 15 percent devaluation in Argentina.

Falling currencies increase the cost of servicing foreign debt and trigger inflation as import prices leap. Weaker currencies should also aid exports by making them cheaper, but the question remains: Export to whom?

European and North American imports are subdued, while slowing growth in manufacturing-driven China makes that market tough for competitors and materials suppliers. Troubles in emerging economies, which account for 50 percent of worldwide GDP, may prove contagious.

The agonizing reappraisal of emerging economies by investors started with the Federal Reserve’s taper talk last May and June. Emerging-market officials never thanked the Fed for creating all those inflows of easy money, but now they blame the U.S. central bank for outflows. To be sure, the human tendency is to blame outsiders for self-inflicted woes.

The Fed, however, shows no intention of bailing these countries out. In 2011, Chairman Ben S. Bernanke said, “It’s really up to emerging markets to find appropriate tools to balance their own growth.” And in response to the current emerging-market crisis, Fed Chair Janet Yellen told Congress in February that those problems didn’t currently pose a threat to the U.S. recovery, signaling no change in the Fed’s tapering policy.

U.S. corporations, however, have considerable exposure to developing economies. In 2011, 34 percent of sales by U.S. multinationals’ majority-owned foreign affiliates were in emerging markets, up from 25 percent in 2000. Emerging markets figure even more prominently in U.S. companies' overseas expansion plans. In 2011, developing countries accounted for 42 percent of capital spending by those affiliates, compared with 30 percent in 2000.

As I noted earlier, since the Federal Reserve began its taper talk last spring, investors have been forced to separate the sheep -- the well-managed emerging economies -- from the goats with their poorly run economies. The sheep -- South Korea, Malaysia, Taiwan and the Philippines -- have surpluses in their current accounts (the excess of domestic saving over domestic investment) from 4 percent of GDP to almost 12 percent as of late 2013. They are exporting that difference, which allows them to fund outflows of hot money. The same surpluses mean the sheep haven’t had to raise interest rates to retain investors' funds.

The sheep also have stable currencies against the U.S. dollar, with exchange rates relatively unchanged since 2009. Moderate inflation of less than 4 percent has been the norm in the sheep countries for several years. The stock markets of the sheep economies have also been fairly flat over the last decade, unlike the less-well-run goats, whose equity markets have sunk. In part 2 of this article, I will explain more fully what makes a goat a goat.

(Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a two-part series.)

To contact the writer of this column: Gary Shilling at insight@agaryshilling.com.

To contact the editor responsible for this column: Paula Dwyer at pdwyer11@bloomberg.net.