An exchange of emails with an international equity strategist of a reputed Wall Street brokerage is the basis of this article. When liquidity is ample and confidence is high, it is usually the so-called “low-quality” or high beta assets that perform better. When both these factors weaken, fortune begins to smile on high-quality assets such as those with stable cashflows, reasonable dividend yield, low valuations, etc., and frowns on low-quality assets. This means large-cap European and US stocks perform better than emerging market stocks—and they have since the financial crisis began around the middle of last year.
The devil is in the details, as always. In the case of emerging markets, we can try to separate the devil from the details by looking at individual regions: Latin America, Asia (excluding Japan), central and eastern Europe. Latin America has far outshone the region with the largest weight in emerging market equity indices—Asia (ex-Japan)—since the beginning of the bull-run in October 2002. In second place come equity markets in central and eastern Europe. Some of them are now beginning to display classic symptoms of overheating: overvalued currencies and current account deficits.
One explanation for the performance of Latin American equities is that the region is a net exporter of commodities while Asia is a net importer. So, their performance can’t be wholly attributed to speculation. Inventories of most commodities are at multi-decade lows. There are riots in Egypt, and Philippine supermarkets are cutting the portions of rice served in their cafeterias by half. Harvests have been erratic and land productivity has stagnated in India and in China.
Among commodities, base metals seem the most stretched. Their ascent since 2002 dwarfs even the pace set by technology stocks (Nasdaq Composite index) in the 1990s. It thus makes sense to be wary of equities that derive their strength from base metals. One should look more closely at Australia and even the UK for downside risks in such a situation. Base metals and crude oil account for 25% of the market capitalization weight of the top 20 stocks in the London FTSE index. Latin America is not driven so much by base metals as it is by energy and agriculture commodities.
The next detail is the extent of price appreciation. For, fundamentals can stay strong but if they are already captured in the price, then it is harder to make the case for further equity market gains. At their recent peaks, since October 2002, in dollar terms, Morgan Stanley Capital International (MSCI) Brazil index has appreciated 12 times (1100%), MSCI India by eight times, MSCI China by about seven times and Russia by a much more modest magnitude.
However, looking at their performance in local currency terms gives a completely different picture. India’s BSE 500 index vaulted 8.5 times since October 2002. Brazil’s Bovespa was a more modest performer rising by about seven times. China’s Shanghai Composite index of A and B shares peaked just at four times the starting level.
So, the spotlight for downside risks turns to India. Not surprisingly, India has corrected the most in recent times. Yet, it is up 500% since the last quarter of 2002. There are good reasons why India outshone many other markets in the last five years. Equally, in the light of recent revelations of corporate greed that have come to grief, fiscal laxity and rising inflation, among Bric (Brazil, Russia, India and China) equities, India stands out for its short-term vulnerability unless crude prices drop prodigiously.
Therefore, some emerging stock markets are at risk of modest to significant losses either because they were propelled higher by sentiment or exuberance ran well ahead of fundamentals as in the case of India. But it does not seem advisable to paint them all with the same brush.
Equally, the classification of developed countries as high-quality and emerging markets as low-quality is well past its “sell-by” date. Decoupling was prematurely trumpeted last year—but its time is now approaching, not so much because emerging markets have emerged, but because the developed ones have submerged. As Kenneth Rogoff and his co-author pointed out, the real developing economy market was the sub-prime mortgage market in the US (Is the US Sub-Prime Financial Crisis So Different? An Historical Comparison, February 2008).
As and when the prices of crude and base metals return to more modest levels, it would embolden many emerging markets to pursue domestic demand-led growth with rising currencies and steady-to-falling interest rates. We would then see decoupling of developing economies from the (mis)fortunes of the American economy. In such a situation, it is also likely that India decouples from the rest of emerging Asia for the worse, simply because it raced far ahead far too quickly.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at email@example.com