No safe haven in emerging markets

published 26 September 2008

"So much for emerging markets being the new safe havens," says Economist.com. Last year many analysts noted that emerging market fundamentals had greatly improved, with many boasting lower inflation and debt, plentiful foreign exchange reserves and current-account surpluses, making them more resilient to financial crises. Emerging middle classes were at the same time beefing up domestic demand and corporate profitability had increased. Indeed, Bloomberg noted last week that emerging-market return on equity has reached 16.8%, the highest since it began tracking this data in 2003.

All this makes emerging markets look enticing over the long term. But for now, the idea that developing markets were "immunised against financial turmoil and recession" in America and elsewhere in the industrialised world, says Rosemary Righter in The Times, has been "shelved". Emerging-market stocks have fallen further than their developed counterparts, with the MSCI Emerging Markets index (after last week's bounce induced by the news of the US bail-out) down 36% from last October's record and off by around 14% this month. China had slipped by 65% from its 2007 apex by last week. The latest survey of global fund managers by Merrill Lynch found their position in emerging-market stocks was the smallest since 2001. Developed-world stocks are down by around 25% peak-to-trough.

At times of heightened risk aversion, risky assets, such as emerging-market stocks, are rapidly ditched. High interest rates in some emerging economies, moreover, had enticed carry traders, who are now deleveraging. Weakening commodity prices have also dented sentiment towards emerging markets and energy and materials stocks comprise 30% of emerging market capitalisation, as BCA Research points out.

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Meanwhile, confidence in economic decoupling is dwindling as the global growth outlook has dimmed. According to Goldman Sachs, countries comprising half the world economy face recession, and the bad news is that developing-market stocks are "far too export-focused"; without demand from America, Europe and Japan, "it's going to be tough", says Ben Inker of GMO. In Asia, for instance, Malaysian industrial output growth has slowed to an 11-month low and Singapore's overseas shipments fell by the most in 20 months in August.

China is losing steam, with industrial production expanding at its lowest rate in six years in August and electricity consumption growth at an eight-year low of 5.1% "alarmingly low", according to Citigroup's Lan Xue. With export momentum deteriorating and the property slowdown denting fixed asset investment as well as consumption, the authorities who trimmed interest rates last week will be unable to reverse the slowdown, reckons Xue. Eastern Europe has been affected by the sputtering eurozone and the impact of the G7 slowdown will soon "become much more apparent" in Latin America, warns Neil Dougall of Dresdner Kleinwort.

As for valuations, the MSCI is on a p/e of 11 for 2008, while earnings are expected to grow by 14%, notes David Stevenson in the FT. But analysts are being too optimistic: "we all know" the earnings forecasts won't be met, he says. He highlights research from Socit Gnrale that shows the cyclically-adjusted p/e which smooths out earnings over the economic cycle is still 35 for 2008, compared to ten during the last bear market.

Note that Marcus Rosgen of Citigroup says Asia ex-Japan's profit per share forecast of 15% in 2009 is "too high". There is scope for some "nasty shocks" on the profits front as growth slows, says Economist.com. For now, "watch from the sidelines", says Stevenson.