Home >market >mark-to-market >Emerging economies contract, developed economies expand

The HSBC Composite Output Index, a survey-based gauge of manufacturing and services output, is showing divergent trends. Recent data show that emerging market (EM) economies are contracting while developed economies are expanding.

Manufacturing and services activity in emerging markets saw a sharp contraction in July, with the composite output index slipping below the 50-point mark which divides contraction from growth. In India, output declined to a four-year low of 48.4. China’s index slowed to 49.5. Russia recorded the lowest business activity since July 2009, at 48.7, while the composite output reading for Brazil was at 49.6.

On the other hand are the developed nations. The composite output index for the euro zone rose to a two-year high of 50.5 as manufacturing production improved, indicating that the region may be exiting slowly out of a very long recession. Among the big four nations, growth was led by Germany, followed by France and Italy, which showed signs of stabilizing. The composite output index in Japan rose to 50.7 and in the US, manufacturing activity accelerated to a reading of 55.4 on the back of a pick-up in orders and production, according to the Institute of Supply Management. Non-manufacturing activity in the US expanded at the fastest pace in five months in July, with a reading of 56.

This divergence between the emerging and developed world is reflected in a great rotation of funds from emerging to developed markets (DMs). In the three months to 2 August, in local currency terms, MSCI China has fallen 4%, India is down 3.8% and Brazil is down 6.9%. During the same period, MSCI US has rallied 5%, while the euro zone and Japan are up 1.9% and 5.4%, respectively, again in local currency.

The big question, however, is: how much of the emerging market underperformance is already discounted by the equity markets? Recall that last month’s Bank of America Merrill Lynch survey of global fund managers found that emerging market equity exposure within a global portfolio was down to its lowest level since 2001. Emerging market profit expectations fell to their lowest level on record and these markets are now viewed as the biggest risk to financial market stability. The pessimism, in short, can be cut with a knife.

Now consider what Morgan Stanley says in a 1 August note: “EM’s relative valuation on a trailing P/B (price to book) basis to DM has now fallen to just 0.73x, from 0.93x at the turn of the year. This is the lowest since early 2004. The last time that EM’s P/B relative was at this level and falling was in late 1995/early 1996 during the hiatus between the Mexican Tequila crisis and the Asian financial crisis. This was a period of decelerating growth and rising funding risks."

The markets are comparing the current situation in emerging markets with 1994, when a sharp rise in interest rates by the US Federal Reserve led to carnage in EM equities.

Is the doom and gloom overdone? And is the time ripe for a rebound for emerging markets? Morgan Stanley does say we may get a modest bounce by year end, but points out that “73% of market cap in EM by sector (particularly consumer discretionary, materials and industrials) is experiencing relative RoE (return on equity) contraction versus DM, while only 27% (healthcare, IT and utilities) is experiencing expansion."

Geoff Lewis, global market strategist at JP Morgan Asset Management, said its overweight on US, Europe and Japan equities, underweight on China and neutral on India because of growth and regulatory concerns. But he does add one silver lining by saying that the strengthening of the US economy is the catalyst for emerging market outperformance as exports would eventually pick up and valuations were getting cheap.

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