Have emerging markets decoupled from the West?

No

Costa Vayenas

Head of Emerging Markets Research at UBS Wealth Management

Imagine if, in 2006, you were asked to describe how emerging market asset prices would react under the following stress test: the global economy finds itself in the fourth year of a financial crisis that has drawn analogies with the 1930s; the United States has lost its AAA rating; the European Union is receiving assistance from the IMF. The problem has become so big that some investors are asking is: Who will bail out the IMF?

This stress test scenario doesn’t give any clues as to how the emerging markets are holding up, but it would have been reasonable to assume that they would not be doing well. It would also have been plausible that emerging market asset prices, equities in particular, would have substantially underperformed global equities.

The surprise, then, is that between the start of the crisis in mid-2007 and the end of 2011, emerging market equities managed to outperform developed market equities by 13.7 per cent in US dollar terms. This tells us something unusual has been happening with regard to the DNA of emerging economies and, by extension, to their equity markets.

Viewed from the history of emerging market equities before this crisis, this is unexpected. But viewed from the perspective of changed fundamentals and an increasingly interlinked global economy, it should not be too surprising that there has been less volatility in the broad emerging market index relative to world equities.

To explain why emerging equities are acting the way they are, one clue comes from the bond market. The decline in the spreads (over US Treasuries) that emerging market governments have to pay to borrow in US dollars tells us that the average emerging market government has become a lot less risky over the past decade. If the perceived risk premium has declined for the average emerging market government, it has probably also declined for the average emerging market company in the equity index.

The other driver of closer correlations between emerging market equities and global equities are powerful global gravitational forces at work.

Due to the rise in international trade, companies and the economies in which they operate are becoming more integrated. Companies in developed markets are doing more business in the emerging markets, and emerging market companies are doing more business in developed countries. Their production chains and revenue streams are increasingly global. Accordingly, to tap into emerging market revenue streams, it matters less where companies are listed. If a hypothetical Austrian dairy producer is making a lot of money selling yoghurt to Asia, then I should have that diary producer in my portfolio if I want exposure to emerging markets growth.

Today, around one quarter of European company earnings come from the emerging markets. Thus, the equity indices of non-emerging economies are more affected by what is happening in emerging markets than a decade ago. And the same is true from the other perspective – emerging market companies are also heavily influenced by economic swings in developed markets. So, increasingly, our developed and emerging market boats are operating in the same waters. This means that the returns of emerging market equities are also increasingly dependent on global economic developments.

It is difficult to see, therefore, how a broad, cross-country index sustainably decouples from the rest of the world. Accordingly, in order to find those jewels that deliver great outperformance, we are going to have to become more selective. We are going to have to be picky about what we buy within an emerging market index and we will need to look for companies located outside of the emerging markets that are successfully tapping into emerging market revenue streams.

Yes

Arjuna Mahendran

Head Investment Strategy - Asia at HSBC Private Bank

The decline in emerging market bourses in 2011, most pronounced in the so-called Bric economies (Brazil, Russia, India and China) has disappointed those who expected a decoupling of these markets from those of the Western developed economies. It has also given rise to the notion, misplaced in our view, that globalisation has made markets more inter-twined through trade and investment links and thus there is no prospect of emerging markets generating superior growth momentum while the West grapples with its debt crisis.

Yet, recent data suggest there are strong fundamental changes afoot in the structure of emerging market economies which will surprise the markets late in 2012 and cause a sudden decoupling in growth expectations. Once that happens, emerging market risk assets, particularly in the second-tier countries just below the Brics, are set to tread a distinctly bullish trajectory independent of their developed market counterparts.

Taken as a whole, emerging market exports have increased from just over 25 per cent of their GDP in 1990 to almost 50 per cent today. While this does make them vulnerable to a slowdown in the US and Europe, consider that while China’s growth in exports to America slowed to 5 per cent (in US dollar terms), exports to Brazil, India and Russia were up by more than 60 per cent, and those to oil exporters by 45 per cent. Half of China’s exports now go to other emerging economies.

Emerging markets are doing their bit to convert the accumulated financial reserves of the last decade into real consumption. The combined current account surpluses of emerging markets as a percentage of GDP has been declining – from a peak of 4.7 per cent in the first quarter of 2007 to about 2.2 per cent in the first quarter of 2011 – indicating that domestic demand has been increasingly taking over the driver’s seat in emerging market economies.

India has been consistently running deficits, while Brazil has switched from surplus to deficit since 2008. Even China, widely depicted as a major villain for global imbalances, has halved its current account surplus as a share of GDP from 10.6 per cent in 2007 to about 4 per cent in 2011. As a consequence, during the global recession in 2008 and 2009, the contribution of Chinese consumers to global consumer demand outstripped that of their American cousins and remained close to matching the US contribution in 2010.

A severe recession in Europe in 2012 could still have a nasty impact on the developing world if commodity prices collapsed and if it caused stockmarkets to fall more steeply, depressing global consumer and business confidence. A sharp fall in the euro could also further squeeze emerging economies’ exports.

But for perhaps the first time, developing countries would be able to make full use of monetary and fiscal policy to cushion their economies. In the past, when they were net foreign borrowers, capital inflows tended to dry up during global downturns as foreign investors shunned risky assets. This forced governments to raise interest rates and tighten fiscal policy. Economies with large external deficits are still vulnerable, but most emerging economies now have a current account surplus and large foreign reserves; many have a budget surplus or are close to balance, leaving ample room for a fiscal stimulus if necessary.

We expect that inflationary pressure in the large emerging markets will reduce considerably by mid-2012 as a consequence of tight money policies, a strong supply response in agricultural commodity markets and depressed external demand for manufacturing exports. This economic slack will create the fiscal space for emerging market governments to re-apply the economic stimuli they utilised in 2009-2010 to pull their economies, along with those of the developed world, out of recession. Yet again.