Most emerging market economies are unlikely to de-couple from the U.S., a premise behind the sharp, brief rally in emerging stock markets last fall. Since the American economy and stock market started weakening in late 2007, so have most emerging markets. Some developing countries may provide short-term investment gains due to specific economic factors. Are these increases sustainable? In this opinion piece, Ignatius Chithelen, managing partner of Banyan Tree Capital Management, an investment firm in New York City, argues that with most gains from emerging stock markets already behind us, it may be time to sell.
Since the summer of 2007, numerous signs of speculative excess have appeared in emerging markets: Stocks in Shanghai and Shenzhen trading at 100% plus premiums to the prices at which the same Chinese stocks trade on the Hong Kong Exchange; reports of Chinese peasants pawning homes to buy stocks; frenzied bidding for IPOs in India of companies with no revenues and earnings; and commercial and residential real estate prices in major emerging market financial centers exceeding those in New York.
But the day the U.S. Federal Reserve began cutting rates last August, in an effort to tackle the growing subprime mortgage mess, some investment advisors and speculators identified emerging stock markets — and commodities — as major beneficiaries of the Fed’s action. These strategists argued that a slowing U.S. economy would have little impact on emerging countries. The reason was that trade among these fast-growing countries was sizeable, they had large and growing domestic consumption, and they had benefited from the booming worldwide demand for commodities. Further, unlike during the last series of crises in emerging markets in the 1990s, these economies were now in good financial shape. They collectively had a current account surplus of more than $600 billion a year, and their total foreign exchange reserves exceeded $2.7 trillion. The speculators, meanwhile, rushed in with the belief that the liquidity generated by the Fed rate cuts would create yet another bubble, this time in emerging markets and commodities.
In just seven weeks following the Fed’s August 2007 discount rate cut, institutions and individuals in the U.S. poured an estimated $24 billion into emerging equity markets. This was $1 billion more than the funds that flowed in during all of 2006, and the emerging markets moved up sharply. The iShares MSCI Emerging Markets Index Fund (EEM), a New York Stock Exchange traded fund (ETF) that is representative of the MSCI Emerging Markets Index, climbed about 50% in less than two months, from late August to late October. But since then, as the U.S. economy and stock market have weakened, so have most emerging markets — the EEM is down about 20%.
Over the five-year period ending December 2007, the MSCI Emerging Markets Index was up 383%, nearly five times the S&P 500 Index’s 83% gain. Astute investors who, back in 2002 and 2003, perceived the growth in outsourcing of jobs from the U.S. and Europe to emerging countries or the rise in demand for various commodities, have enjoyed big gains by buying stocks, funds or ETFs that provided the country and/or industry exposure to such changes. One widely reported example is Warren’s Buffett’s estimated profit of $3.5 billion from the sale of PetroChina stock in mid 2007 — a 500% plus gain in four years. So, looking in the rearview mirror, most if not all of the big relative gains from investing in emerging markets may be behind us.
Meanwhile, the economic underpinnings of these countries’ growth could possibly weaken. Even though the domestic economies in major emerging markets are large, U.S. demand still continues to be a dominant factor. American consumers are estimated to have spent some $9.5 trillion last year, more than twice what consumers spent in all emerging countries put together. In the two emerging countries with large populations, consumer spending was approximately $1 trillion in China and $600 billion in India. So the slowdown in U.S. consumer spending, which could be long-lasting and deep, may hurt overall demand for goods and services from emerging markets, even assuming their internal consumption continues to grow.
One impact of falling demand from the U.S. on emerging market economies will be a drop in exports. Roughly 20% of exports from China, India and Brazil go to the U.S. This figure, though, likely understates the size of effective exports to America from places like China and India. This is because some exports, as in the case of certain Chinese exports to Japan, end up as inputs for items that are then exported to the U.S.
In addition to the impact of a slowing U.S. economy, some emerging markets themselves face troubling issues. An immediate and major concern is the rise in inflation, which has already crippled Vietnam’s economy and stock market and is affecting China and other countries.
I believe India’s financial position is weaker than it might appear. The country has foreign reserves less foreign debt of about $100 billion, imports of crude oil needed to cover 85% of its 2.6 million barrels per day (bpd) consumption, a domestic budget deficit/GDP of 8% in 2007 and total public debt/GDP of 73%. China is in a strong position with a net $1.2 trillion of foreign reserves. But China imports nearly half of the seven million bpd in crude oil it consumes, and it also depends on substantial imports of minerals and food items.
Infrastructure bottlenecks — power shortages, congested ports, inadequate roads and railroads — abound in emerging markets like India, Brazil and South Africa and these countries lack funds to tackle these problems. Moreover, the growing gulf between rich and poor could lead to social unrest and political upheavals, whose outbreak could trigger an outflow of U.S. funds in a fearful hurry.
During the emerging markets boom of the 1990s, fund flows from the U.S., as well as Western Europe and Japan, flooded in near the peak and just before many of the emerging markets collapsed due to internal or external factors. For instance, assets in emerging market mutual funds in the U.S. rocketed up from only $150 million in 1990 to $27 billion in 1996. Lots of money flooded in just before the collapse in emerging markets following the Asian financial crisis of 1997 and the Russian crisis of 1998.
A similar fund-flow pattern seems evident in the current cycle. Some 1,700 emerging market stock funds have attracted more than $150 billion of assets in the U.S. In 2007 alone, the in-flow into these funds was about $41 billion, 80% greater than in the previous year. Again, most of the funds poured in late, chasing past performance. The EEM alone now has some $26 billion in assets, $10 billion more than a year ago, and is the third largest ETF in the U.S.
Together with fund flows from Western Europe and Japan, which tend to mimic ebbs and flows from the U.S., the total funds from developed countries in emerging stock markets is likely to be well in excess of $200 billion. The stock market float of Brazil, Russia, India and China — marketed collectively as the BRIC countries — is at best $1,200 billion and that of emerging markets as a whole about $1,500 billion. So, the fund flows from the developed countries account for roughly a sixth of the entire tradable value of emerging stock markets. Little wonder that these investments have had a major impact on prices in these markets.
Inflows and Outflows
But the fund inflows from the U.S. can reverse fairly quickly into outflows, due to investment losses, signs of trouble and a lack of confidence, compounding any declines in emerging markets. This happened during the late 1990s and is already occurring this year. As emerging stock markets continued their post-October 2007 decline, in just one week — the third week of January 2008 — U.S. outflows from emerging markets totaled $11 billion, a quarter of the total inflow from the U.S. during all of last year.
I don’t mean to paint a picture of unmitigated doom-and-gloom. In the short term, some emerging markets will benefit from rising demand and prices for crude oil, fertilizers, food grains and other commodities. Russia is in a good position, given that it exports six million bpd of crude oil and also other minerals. In addition, the country has roughly $300 billion in net foreign reserves and good domestic finances. But the control of its resources by a shareholder un-friendly oligarchy, tied to the effective one-party rule of President Putin, does not offer good prospects. Brazil is in a good position, too, given its agricultural and mineral exports and its crude oil deposits. The BRIC country markets have indeed de-coupled — at least from one another. Since October, while stock markets in China and India have continued to fall, those in Russia and Brazil have recovered from their initial drop.
In the future, after the current euphoria and fund inflows ebb away and the business economics and stock valuations become attractive, opportunities for big relative gains will reappear in emerging markets. Also, early identification of the beneficiaries of major long-term supply demand changes will produce some huge winners, such as some Indian IT firms whose stocks have gone up manifold since the early 1990s. Before that history repeats itself, though, I believe gravity will bring stock market valuations back to earth in the emerging markets.