- By Adria Cimino and Michael Patterson
July 13 (Bloomberg) -- The last time stocks in developing countries got this expensive was in October 2007, just before the MSCI Emerging Markets Index began a 12-month tumble that erased half its value.
The MSCI gauge trades at 15.4 times reported earnings, compared with 14 for the Standard & Poor’s 500 Index, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.
Groupama Asset Management, Palatine Asset Management and Standard Life Investments say the disparity means investors are paying too much for shares from China to India to Brazil at a time when the global economy is contracting. MSCI’s emerging- market gauge is valued at 1.7 times its companies’ net assets after a 34 percent surge last quarter, the highest on record compared with the MSCI World Index of 23 advanced economies, which trades for 1.5 times, data compiled by Bloomberg show.
“Emerging-market stocks are at risk,” said Matthieu Giuliani, a Paris-based fund manager at Palatine, which oversees $5.56 billion. “You should only pay so much for growth.”
Investors are already starting to show a lack of confidence in a continued rally. The MSCI developing-nation index dropped 8.3 percent from its 2009 high on June 1 through last week, while the MSCI World fell 7.4 percent and the S&P 500 retreated 6.8 percent. Emerging-market funds had $540 million of net outflows in the week to July 8, the second time in three weeks investors withdrew money, according to Cambridge, Massachusetts- based EPFR Global, which tracks funds with $10 trillion worldwide.
Volatile Returns
The MSCI emerging-market index declined 1.8 percent to 723.05 as of 4:58 p.m. in New York today. The MSCI World added 1.5 percent, while the S&P 500 increased 2.5 percent.
All 22 emerging-market currencies tracked by Bloomberg depreciated against the yen in the past month, and 16 weakened against the dollar. The yen usually attracts investors during economic turmoil because Japan’s trade surplus makes the nation less reliant on overseas lenders, while the dollar benefits from its status as the world’s reserve currency.
While developing nations’ economies grew an average 1.7 times faster than developed countries in the past 20 years, their stocks traded at a discount because their economies and returns were more volatile. Brazil’s annual inflation averaged more than 1,000 percent in the 1990s, and South Korea required a $57 billion bailout from the International Monetary Fund during the Asian financial crisis of 1997.
Bull Markets
The MSCI emerging-market index had 13 bull-market rallies of at least 20 percent and 12 bear-market declines of the same magnitude since its inception in December 1987, according to data compiled by Birinyi Associates Inc., the Westport, Connecticut-based research and money management firm founded by Laszlo Birinyi. That compares with five bull markets and four bear markets for the S&P 500 during the same period.
Developing nations led the worldwide rally in equities last quarter, with China’s Shanghai Composite Index adding 25 percent and India’s Bombay Stock Exchange Sensitive Index jumping 49 percent. The gains outpaced a 20 percent rise in the MSCI World and a 15 percent advance in the S&P 500.
The increase cut the dividend yield of the emerging-market gauge to 2.97 percent, compared with 3.49 percent for developed countries. MSCI’s emerging-market index fetches 1.1 times sales and 6.7 times cash flow, compared with 0.8 and 4.3 in the advanced gauge, data compiled by Bloomberg show.
Record Share
“Gains came too quickly in the context of a slow economic rebound,” said Romain Boscher, who helps oversee $119 billion as a director at Groupama in Paris. “Valuations are now high, and that leaves the door open for a drop. Emerging and developed markets are at risk.”
Developing nations’ share of global equity value climbed to an all-time high this month as investors poured in a record $26.5 billion last quarter, according to data compiled by Bloomberg and EPFR.
The infusion helped Beijing-based oil producer PetroChina Co. climb 17 percent in Hong Kong trading this year and overtake Exxon Mobil Corp. as the world’s largest company by market capitalization. PetroChina’s shares are valued at 11.3 times earnings, compared with 8.9 for Irving, Texas-based Exxon.
PetroChina, which traded at a discount to Exxon as recently as April, is one of five Chinese companies ranked among the world’s 10 biggest by market value. The rest are in the U.S.
Growth Premium
Itau Unibanco Holding SA in Sao Paulo, Latin America’s largest bank by market value, trades at 2.7 times net assets, more than double the 1.1 price-to-book ratio for Banco Santander SA. The Santander, Spain-based lender got 33 percent of its net income from Latin America in the first quarter and is the world’s 10th-biggest financial company by market value.
For Carmignac Gestion’s Eric Le Coz, emerging-market equities deserve a premium because the economies are the only ones projected to grow this year. Financial institutions in developing nations also avoided most of the credit freeze that caused almost $1.5 trillion of writedowns and credit losses since 2007, according to Bloomberg data.
Le Coz’s firm is buying shares of Beijing-based China Construction Bank Corp., which trades for 2.5 times book value, and Bharat Heavy Electricals Ltd., the New Delhi-based manufacturer of power-plant equipment that’s valued at 31 times earnings.
Not as Fragile
The Washington-based IMF estimates developing economies will grow 1.5 percent as a group this year and 4.7 percent in 2010, while advanced economies will contract 3.8 percent in 2009 and expand 0.6 percent next year.
Emerging markets “should be more expensive,” said Le Coz, who helps oversee $28 billion as a member of the investment committee at Carmignac in Paris. “In the past, emerging markets were fragile. Today that’s not the case.”
Brazil, which defaulted on its foreign debt twice since 1983 and devalued its currency in 1999, now has an investment- grade credit rating from S&P and Fitch Ratings. Moody’s Investors Service said this month it may upgrade Latin America’s biggest economy.
Chinese stocks are among the world’s best investments because the nation’s economic growth is poised to exceed forecasts, Barton Biggs, who runs New York-based hedge fund Traxis Partners LP, said in an interview on Bloomberg Television today.
China surpassed Germany in 2007 to become the world’s third-largest economy. Russia has $409 billion of foreign exchange reserves and India has $253 billion, the world’s third- and fifth-biggest holdings, according to Bloomberg data.
‘Grave’ Prospects
Developing nations traded at a discount to American equities from 2001 to 2006 even after their economies expanded at almost three times the pace, according to Bloomberg and IMF data. They moved to a premium in October 2007, the peak of a five-year advance that sent the MSCI gauge up fivefold. The index’s drop in 2008 was almost 16 percentage points steeper than the S&P 500’s 38 percent slide, the worst since 1937.
When emerging-market valuations climbed above the U.S. in 1999 and 2000, it foreshadowed the end of a seven-year global rally. The MSCI developing-nation index sank 37 percent in the 12 months after March 2000, compared with a 23 percent slide in the S&P 500.
The Washington-based World Bank spurred a worldwide sell- off last month after warning of “increasingly grave economic prospects” for developing nations and predicting the global economy will contract 2.9 percent this year, compared with a previous forecast of a 1.7 percent decline.
Equities sank on July 2 as the U.S. government said the economy lost 467,000 jobs last month, 102,000 more than the median economist’s estimate.
‘Run Too Far’
Emerging markets “are still dependent on exports and the health of wealthy countries,” Palatine’s Giuliani said. The European Union was the biggest export market for Brazil, Russia, India and China as of 2007, the last period the data were available, according to the Geneva-based World Trade Organization. The U.S. was the second-biggest market for Brazil, India and China.
Shares in developing nations are the most vulnerable to further declines because prices “have run too far ahead” of a recovery in profits, according to Standard Life’s Jason Hepner.
Profits Plunge
Companies in the MSCI emerging-markets index that reported results since the end of the first quarter posted an average earnings drop of 92 percent, trailing analysts’ estimates by 14 percent, according to Bloomberg data. That compares with a 46 percent profit slide for Europe’s Dow Jones Stoxx 600 Index and a 31 percent fall for the S&P 500, Bloomberg data show.
“We favor the more defensive markets like the U.S.,” said Hepner, an Edinburgh-based money manager at Standard Life, which oversees about $178 billion worldwide and has a “very light” position in emerging-market equities.
While BlackRock Inc.’s Bob Doll projects developing-market equities will be the most attractive stock investments over the next few years, he says they may lead a short-term retreat as investors reduce expectations for an economic recovery.
“A lot of risk assets are ahead of themselves,” said Doll, vice chairman and chief investment officer of global equities at New York-based BlackRock, which had $1.3 trillion under management as of March 31. “Almost always, what goes up the most, pulls back the most.”
In another article WSJ - Small Investors Pile into Emerging Markets, Junk Bonds, and Commodities
- Emerging Markets - aka decoupling all over again
•Stock markets of developing countries like India and Brazil have gone through the roof since early March, reversing some of their declines from last year. The MSCI Emerging Markets Index is up about 34% for the first six months of the year, after losing 54.5% in 2008. Some niche markets have had wilder swings. Russia’s benchmark RTS index is up 56% for the year’s first half, after losing 72.4% in 2008. [May 24, 2009: NYT - As Economy Struggles, Russia's Market Has Surged]
•What’s changed? Not only do investors have a greater appetite for risk these days, they’re also more optimistic about the economic outlook for some of these countries. In China, the world’s third-largest economy, the government’s massive stimulus is starting to take effect. While exports are still down, internal growth is gaining strength. Meanwhile, commodity prices have been on the rise, improving confidence in Brazil and Russia.
•Despite hot performance for emerging-market funds so far this year—an average 33% return—some money managers say caution is in order. While they’re optimistic that emerging-market economies will grow at a much faster rate than the U.S. over the next several years, some worry about the recent explosive rally in these markets. “It’s been the lower-quality, the riskier companies that have done better this year,” says Simon Hallett, co-portfolio manager of the Harding Loevner Emerging Markets fund. “Emerging markets have probably overshot in the short term.”
Morgan Stanley too had something to say, US revival key to emerging market recovery: Morgan Stanley
- China’s role in the global economy is currently similar to that of the little Dutch boy who stuck his finger in the dyke to avert disaster. It is the only country where growth has returned to its underlying trend rate of 8% following last year’s economic meltdown. The demand impulse from China is now buoying exports and sentiment in several other economies.
However, the boy could only stem the tide up to a point and fortunately other men soon arrived on the scene to fix the problem. As was the case in the Dutch legend, the global economy too needs the developed world to start contributing to world growth again for a broad-based recovery to materialise. And that in turn requires the US consumer to spend at least a small part of the stimulus funds pronto.
Even China is betting on the US consumer making some sort of a comeback. While Chinese policymakers are indeed attempting to reorient the economy by encouraging more domestic consumption, such structural changes take a long time to pan out. Boosting infrastructure spending is the quickest way to shore up demand in the short-term and that’s what China has done over the past few months. A large part of the Chinese stimulus has gone towards increasing fixed asset investment even though investment as a share of GDP is already at abnormally high levels of more than 40%.
China essentially remains the world’s main manufacturing base. And herein lies the problem with the global economic recovery story. It will be very difficult for China to maintain its 8% expansion pace if its export growth does not pick up by the end of the year as there’s a limit as to how much investment it can add to its already large and increasingly idle manufacturing base.
The rise in economic optimism since March this year has largely been due to a turnaround in the manufacturing sectors in many countries, starting with China. Manufacturing activity that declined across the world by more than 15% in the year to March 2009 began to stabilise in the first quarter of 2009 with Asian countries taking the lead. Expectations rose that the snapback in industrial activity could be quite sharp as firms had aggressively cut production and their workforce late last year following the credit crisis.
Some developing countries are indeed on track to post eye-popping growth numbers for the second quarter. Many Asian emerging markets probably recorded economic growth in excess of 10% on an annualised basis in the April-June 2009 quarter. For the developed world as well economists are projecting positive growth in the July-September quarter with the rate of inventory liquidation having peaked in the first half of 2009.
Global equity markets were on a tear since March, tracking the sharp improvement in economic sentiment. But after pricing in all the positive developments on the global manufacturing front, the stock market rally stalled in June and is now showing signs of fading as the realisation dawns that any rebound in manufacturing activity may just be a short-term phenomenon if final demand does not resurface.
Unfortunately, the news on the consumption front has been discouraging of late. It appears that the US consumer has used all the additional income from the stimulus packages to just rebuild the savings pool. The household savings ratio has risen from virtually zero in late 2007 to 6% currently. That’s a huge swing in a short span of time although it is still below the historical norm of 8%. No meaningful global economic recovery can shape up as long as the US consumer stays completely focused on increasing the savings ratio. After all, consumption drives growth, not manufacturing activity as the latter is undertaken only in anticipation of final demand.
The most important data then to track in the weeks and months ahead are US retail sales numbers. While the US consumer is unlikely to return to the spendthrift ways of the past two decades for a long time to come, a modest increase in retail sales is now required to create some sort of a virtuous economic cycle. Over time, the US consumer needs to work off the excessive leverage and gradually increase the savings rate while the rest of the world makes the necessary structural adjustments to the growth model. In the long-run, final demand trends of the developed world will play a less significant role and the growth leadership has to be provided by the emerging market consumer. But decoupling is an incremental process and given the trade and capital flow linkages, developing countries cannot pull away from the developed world too far, too quickly.
The decoupling theme staged some sort of a comeback this year after being derailed by the economic crisis in 2008. This is reflected in the relative performance of emerging markets versus developed markets: the gap between the indices of the two blocs is back at the levels last seen at the peak of the decoupling mania in late 2007.
Equity market performance merely tracks economic sentiment on a real time basis and the large performance gap between the emerging and developed market indices indicates the differential in sentiment is stretched from a historical perspective. To be sure, there’s nothing to suggest that the differential can’t get wider. The valuations of stocks in developing countries are currently similar to those in the developed world after long trading at a discount and a case can be made that emerging market equities should trade at a premium as their future growth prospects are brighter. In the near-term however, it’s hard to justify much of a premium as the export dependency and the reliance on external capital to fund some of their growth is still high among many developing economies.
Ironically, both the performance and valuation gap between the developing and the industrialised world could further widen in the coming months if risk appetite in the US and other developed countries rises. That in turn will lead to an even greater inflow of capital into emerging markets. For that to happen though economic optimism in the US must improve.
It’s then all down to the US consumer to determine whether a global economic recovery gains traction by moving beyond the inventory rebuilding stage. If the US consumer remains in a funk and keeps on saving any additional income the world economy will at best follow an L-shaped economic path, implying that the cyclical bull market in equities is over. But even a modest revival in US consumer activity will be enough to create a positive feedback loop between production and consumption and extend the cyclical bull market in stocks till at least early 2010 when fresh challenges will emerge as the stimulus effects fade and excessive leverage in the system remains a drag.
The bears argue that the consumer will keep on retrenching this year as the economic wounds of the past year are still raw and the debt overload high. They do have history on their side: it has typically taken around three years for the US economy to find its footing after suffering a major crisis. The first phase of the Great Depression lasted three years from 1929 to 1932. In a disturbing parallel, the stock market rallied by 30% in early 1931 as industrial activity seemed to be stabilising following a market crash of nearly 50% in the previous year. But the consumer deleveraging process continued unabated that subsequently took the economy and the markets for a deeper dive. Even during a mild recession in 2001 following the tech boom-bust cycle, it took till mid-2003 for consumer spending to accelerate despite industrial activity having bottomed in late 2001 and showing a rebound in early 2002.
Of course, the difference this time around is that the world has never seen so much money thrown at a problem. The bulls are banking on that cash infusion to launch a sustained global recovery. China’s policymakers have already succeeded in stimulating their economy but beyond a point, it too needs the largest buyer of its goods — the US consumer — to start spending again. If that doesn’t happen soon enough, then the global economy faces the prospect a relapse.
Here's how EEM has been faring since December 2008.
Rather important. Compare this to postings made last month, Squeaky Bum Time For EEM and How Did EEM Fared So Far During Its Squeaky Bum Time?
Do also see the two contrasting view points made on emerging markets on the recent posting Market Outlook For Emerging Markets, where we have Mark Mobius being rather optimistic and fundamentalists like Claire Barnes acknowledging the deep concerns.
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