New markets also dragged by slump

Dec 17 2008 by Andrew Miller, The Journal

THE alleged decoupling of emerging markets – the suggestion that emerging economies could carry on regardless despite a sharp slowdown in the developed world – has been well and truly laid to rest.

Since the beginning of June, the MSCI Emerging Markets index has lost about half its value in local currency terms. Indeed, the sharp outflow of foreign capital has been such that some countries – such as Hungary and Ukraine – have been forced to turn to the International Monetary Fund for help.

So what does 2009 hold in store for emerging markets? Growth forecasts for 2009 have come down quite sharply in recent months and we suspect that this process has significantly further to run.

The consensus forecast is for emerging economies to expand by about 4% in 2009, compared with 7.5% and 6% in 2007 and 2008 respectively.

There will be a noticeable divergence in economic growth in 2009, however. The large countries, such as the Brics (Brazil, Russia, India and China) – where exports are a comparatively smaller proportion of GDP and policymakers have significantly greater scope to boost activity through policy easing – should be able to maintain pretty decent expansion when judged in a historical context, although India arguably has less scope in this regard than the other Bric nations.

Perhaps most notably, China has already unveiled a huge fiscal stimulus plan with the aim of boosting infrastructure spending and it is clear that the authorities have plenty of firepower to stimulate growth, should it be needed.

By contrast, many of the highly leveraged Eastern European countries (where numerous asset price bubbles have burst) and the smaller, internationally-exposed Asian and Latin American economies are likely to contract, or at the very best, register very anaemic rates of economic growth next year.

Of course, emerging market equities are basically a geared play on global equities, outperforming significantly on the way up, but underperforming by a more or less equal margin on the way down.

Given these characteristics, it is perhaps unsurprising that they have fared poorly of late. Moreover, indiscriminate selling and investors’ outright rejection of riskier assets has meant that even countries with strong fundamentals have been sold off sharply.

Over the coming year we have slightly more cause for optimism. On a valuation basis, emerging equities look very attractive compared with their own history and they are now trading at a discount to their developed peers.

Crucially, as financial markets begin to “price out” the possibility of a Depression-style scenario, global equity markets – and emerging equities as a geared play – should rally strongly in the second half of 2009.

That said, we suspect that country selection will be very important next year, as increasingly risk-averse investors are likely to be more discriminatory than in the past.

With some exceptions, we would generally prefer the Bric countries, where growth prospects are much brighter and balance-of-payment positions are generally much healthier than in other emerging nations. We particularly favour China and Brazil, whose policymakers have significant further room for manoeuvre to support growth if necessary. Although Russia has sold off heavily in recent months, political risk and uncertainty weaken the investment case here.

Indeed, the recent volatility in emerging equities underlines just how important a disciplined investment approach is in these markets.

Andrew Miller is regional office head of Barclays Wealth