Sizzle and fizzle

Sizzle and fizzle

The stock markets are on fire. Barely two months after the credit crisis hit the developed markets, the Bombay Stock Exchange Sensex is making new highs almost every day. There’s little doubt that the immediate trigger for the rise is the 50 basis point rate cut by the US Federal Reserve, which pleasantly surprised the markets. Many other emerging markets have rallied and the Morgan Stanley Capital International emerging markets index also scaled an all-time high. Moreover, emerging markets have rallied far more than the developed markets, where the ghost of the subprime crisis continues to linger.

Equity strategists have been quick to observe that the recent sell-off was, in a sense, 1998 in reverse. In that year, the crisis occurred in emerging markets. The US Fed cut rates then led to a flood of liquidity into the US markets, most of which went into tech stocks. Indeed, it has been argued that the tech boom in the late 1990s was nothing more than a gush of liquidity flowing out from tottering Asian markets into the US, aided and abetted by the rate cuts. This time the rate cuts are unlikely to help the US or, indeed, developed markets. Why should investors put their money into markets when there is every likelihood that more casualties of the subprime meltdown will be found? And why should they put their money into an economy teetering on the brink of recession? Emerging markets, with their high growth rates, look a far better bet.

That raises the interesting point whether emerging economies have decoupled from the US. Clearly, the impact of the crisis on emerging markets showed that the markets have not decoupled. How can they, when emerging markets are so dependent on foreign investors? The few that have restrictions on foreign investment, such as mainland China, ignored the crisis completely. But, for most emerging markets, foreign investment is often the most important determinant of stock prices. As long as that is the case, a decoupling of markets is impossible. In an age when capital is free to roam the world, any talk of decoupling should be met with some scepticism. It may very well be that there’s some amount of divergence among economies.

The global economy is no longer dependent on the US as its sole engine of growth. China has already emerged as an economy that can make or break commodity prices. Even Europe, long derided for its sluggish ways, is doing relatively well. And all this has happened over a period in which US growth has been tepid. While decoupling may be too strong a word to use, the emerging markets are no longer as dependent on exports to the US as they were before. That doesn’t mean, of course, that the Asian economies will not be hurt by a US slowdown. But the impact will be less than earlier. Relatively insular countries such as India whose economies are driven by domestic demand will be the least affected.

Part of the flows to emerging markets, therefore, is undoubtedly driven by economic fundamentals. Companies in these markets have far higher earnings growth than those in mature economies. As a matter of fact, it is those US companies that have overseas operations which have been showing good growth recently. It is also true that emerging markets have benefited from the increase in risk appetite in recent years, which has been at least partly the consequence of loose monetary policy in the US.

Several emerging markets are almost certainly in the bubble territory, the Chinese market being the obvious example. Even the “fundamentals" have been boosted by the increased liquidity, as it has enabled interest rates to stay low and facilitated corporate borrowing abroad. The good news is that emerging markets are fast becoming an asset class indispensable to the portfolios of even conservative investors.

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