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More trouble ahead for emerging markets

August 22, 2013: 9:00 AM ET

A top strategist at Morgan Stanley sees more bearish times for BRICs and a little bit of hope in Europe.

Ruchir Sharma

Ruchir Sharma, emerging markets strategist for Morgan Stanley

FORTUNE -- In recent weeks, emerging markets, long seen as the darlings of the global economy, have tumbled. Cash is flowing out, pushing down the values of stocks, bonds, and currencies in India, Indonesia, and elsewhere. Brazil's problems have been well documented and are boiling over. China's long guaranteed growth is unsure.

Ruchir Sharma, who is the head of Morgan Stanley Investment Management's emerging markets team, saw it all coming. For a long time, Sharma's bearish calls were overshadowed by Goldman Sachs's Jim O'Neill, the former emerging market strategist and China perma-bull who left the bank earlier this year. But in his book, Breakout Nations, which came out early last year, Sharma said the notion that China and other developing nations would soon overtake the West as the drivers of the world economy was bogus. On Wednesday, Sharma talked to Fortune about what's next for China, Brazil, and others. The Morgan Stanley (MS) strategist says he thinks the emerging market selloff won't end anytime soon.

You have long been one of the few emerging market bears. Are you pleased that your dire predictions are coming true?

I think I was bearish, but only relatively. The optimism around emerging markets reached crazy levels back in 2009 and 2010. There was this general view that all the emerging markets will rise, and that the West was in permanent decline. What I saw was deep structural problems in Brazil and India and elsewhere that were largely being ignored. The reality is that some emerging countries will do well, and others won't, and I think the market is starting to realize that.

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So it's not just the Fed?

That is the proximate cause of what has caused the current turmoil. And you have seen that the countries that are running a current account deficit, meaning they rely on foreign capital, have done the worst recently. But liquidity is not the only issue. We also have had this massive credit binge in China, perhaps the largest in economic history. That's coming to an end. And China is the 800-pound gorilla in the emerging markets. So as China slows, all the countries that have benefited from it will slow as well.

But aren't there signs that China is rebounding?

My view is that China is moving to a slower growth plane, say 5%-6%, and that it will move to that trend line in the next year or so. That's not a hard landing, but I don't think the market has priced that in.

How real are Brazil's problems?

I don't see Brazil, or Russia or South America for that matter, growing faster than the U.S. over the next three to five years. And that's really disappointing because the per-capita income in those countries is about one quarter of what it is in the U.S. Brazil relied heavily on the commodities boom, and they misspent the windfall on things that kept their citizens happy but at a very basic level, and not on infrastructure that would have provided a real, lasting benefit. Now what you have is the commodity boom abating, and I don't see where the new growth comes from.

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What you are predicting doesn't sound so positive for the U.S. economy either.

If the emerging markets have a complete crash, then I don't think the U.S. can do well. No economy in the world will survive if China's economy implodes. But that's not my base case. What I am talking about is a gradual shift away where you see the large emerging markets slow down at the same time that confidence and capital is returning to the U.S., Japan, and other developed nations.

So where you would you be putting your money now?

My best bets are countries where economic reform is happening and where there is new political leadership. That's happening in the Philippines and Mexico and Pakistan. Morgan Stanley Investment Management has recently been putting money into Eastern Europe. We see value there. The fundamentals of Poland and others are quite good, and there are signs that Europe is pulling out of its recession.

So you think Europe's problems are behind it?

Europe will never have a V-shaped recovery because of its imbalances. There's still too much debt and the demographics are worse than in the U.S. But the fact that they are pulling out of a recession should be good for Poland and others.

Are you proud of driving Jim O'Neil out of a job?

No comment. I heard he retired.

Raghuram Rajan [another Indian economist who is famous for warning the Fed about the financial crisis] was recently picked to be the head of India's central bank. Jealous?

(Laughs) No. I am happy where I am. Rajan is a very smart guy, but he's got a tough job. Indian's fundamental problems are very deep, deeper than anything a good central banker can fix.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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