Funancial Times still expect a test. Long for the days of the "flight to quality":
Emerging markets face test of strength
By Joanna Chung in London
Published: December 20 2007 01:12 | Last updated: December 20 2007 01:12
Usually when there is a financial crisis, emerging market assets are among the first and hardest hit. Not this year.
In fact, one of the most notable features of the ongoing credit market turmoil has been the spectacular performance of emerging markets – and their resilience amid one of the worst financial crises in recent history.
1But the real test of the sector’s new-found strength will come next year, when global economic and market conditions are expected to worsen.
“A consensus view has formed that the structural changes in emerging markets in recent years mean that the asset class can no longer be compared to the fragile crisis-ridden asset class of the past,” says Marc Balston, head of emerging markets quantitative research at Deutsche Bank.
“We support this view, but also acknowledge that it hasn’t yet been tested. 2008 could well be the year in which the perceived resilience of emerging markets is truly tested.”
There are many reasons to be optimistic. The current crisis, unlike many in the past, originated from the western financial world, not emerging markets, which have been enjoying a bull run for five years.
So in spite of the barrage of bad news that has emanated from credit markets since the summer, investors have continued to pour money into emerging market funds.
Fourth-quarter inflows into emerging market funds currently account for 57 per cent of the year-to-date total of a record $44.5bn, according EPFR Global, which tracks global fund flows.
Brad Durham, managing director of EPFR Global, says the flows have been underpinned by investor appetite for exposure to the larger emerging markets, including the so-called “Brics” (Brazil, Russia, India and China).
The MSCI emerging markets index has gained 30.2 per cent since January. The risk spread of emerging market debt, as measured by JPMorgan’s EMBI+ index, is 234.5 basis points over US Treasuries – low by historical standards.
Part of this cheery investor sentiment is being fuelled by the fact that emerging economies – with a few exceptions – are in better shape than ever to weather financial difficulties. Many governments have been paying off public debt, are running budget and/or current account surpluses and have strong foreign exchange reserves. As a group, emerging markets are a net creditor to the US.
Many are commodity exporters and many commodities have seen spectacular price rises in recent years. The commodities boom is one reason Africa has been capturing growing investor interest and that trend is expected to continue next year, analysts say.
Moreover, fast-growing emerging Asia, including China and India, and the Middle East, which are flush with liquidity, are likely to be play an increasingly key role in the global capital markets in coming years.
Indeed, some investors are convinced that economies in the rest of the world have become decoupled from the US. So even if the US economy slows, the rest of the world, and particularly China and India, will not.
Jing Ulrich, head of China equities at JPMorgan Securities, says that although the fates of the Chinese and US economies are linked, the US contribution to China’s economic growth has fallen in recent years.
However, the ability of China and other emerging markets to weather difficulties next year will largely depend on the magnitude of the crisis in the developed markets, which may prove to be deeper than expected.
“A significant destruction of wealth is taking place both in household and financial sectors,” says Arnab Das, global head of emerging markets research at Dresdner Kleinwort.
“It is going to be a tough year worldwide with a slowdown in the US and G7 countries and a rising risk of recession in the US and the UK. This will require emerging markets, especially the major ones, to become more reliant on domestic demand.”
Emerging market countries are already far less dependent on US growth than in the past and intra-emerging market trade now exceeds trade between emerging markets and industrial countries, says Oussama Himani, strategist at UBS.
“Yet, to claim that emerging markets are immune to a US slowdown is very dangerous,” says Peter Eerdmans of Investec Asset Management. “We would expect emerging markets to slow down as well if the US and Europe slow, as a lot of exports still end up with the western consumer.”
In addition, a surge in inflation is already a growing concern in a number of emerging economies. This is partly due to large inflows due to trade and investment inflows. On top of this, rising commodity, energy and food prices and a falling dollar, to which many EM currencies in effect remain pegged, threaten to import even greater inflation pressures, says Mr Das.
A commodity price shock would hurt a swathe of economies, particularly in Latin America, including Brazil, Venezuela, Colombia, and Ecuador. A further deterioration in the financing environment could put further pressure on economies that are vulnerable to difficult credit conditions, including Kazakhstan and several eastern European economies.
Emerging market assets are also more expensive than they were a year ago. Emerging market equities now trade “at parity” with developed market equities and emerging market debt is more expensive relative to US credit, says Michael Hartnett, global emerging market equity strategist at Merrill Lynch.
Given the potential hazards and the likely volatility, investors will probably be increasingly discriminating about their investments in 2008. In other words, optimism about a sixth consecutive boom year – which would be unprecedented – is being tempered with a great deal of caution.
This article is the third in a series looking at the prospects for markets in 2008 |
