Emerging Markets: Crash and Burn?

You can't have a decent emerging markets crisis until Argentina does something crazy, and right on cue, here they go again. This time they have hatched a plan to nationalize all private pension savings, sending the local market diving 25% in two days.

Who knows, maybe it will catch on. I'm sure Hank Paulsen would love to get his hands on those (fast declining) trillions in 401k plans right now. If you're going to socialize the economy, do it properly. Just about every strategist and 'celebrity' investor like Jim Rogers and Mark Mobius recommended overweighting emerging market equities right up until the crash this summer, on the ludicrous basis that they would 'decouple' from the downturn in the US. There could be no repeat of the 1998 crisis, because their central banks were now awash in foreign currency reserves.

Unfortunately, that shoddy analysis ignored not only the fact that emerging market equities were historically expensive versus developed markets, but also the precarious finances of leading emerging market corporates, who had gone on a wild acquisition spree in the US and Europe, reliant on a sustained boom in commodity revenues to service the hard currency debt they had accumulated.

The dramatic dollar rally of recent months started with unofficial intervention in July, was fuelled by short covering, notably the unwinding of US$ carry trade positions, was boosted by momentum buying plus deleveraging in commodity trades, followed in recent days by panic emerging market corporate buying to cover dollar borrowings and unravel currency hedges gone bad (eg Citic Pacific in HK, which lost $2bn on an open ended long AUS$/short US$ bet). The Mexican Peso plunged 20% in October, leaving dozens of leading companies like Cemex, who had bet against volatility (and implicitly bet on sustained high oil prices), to take huge losses.

I warned on 4th September in "Mexico: Running out of Oil and Options", that the country faced a looming political and economic crisis and would become a major headache for the new US administration. Russia has been particularly hard hit, as I warned it would be on 11th August in "Russian Roulette"; hubristic plans to launch a fleet of new nuclear submarines look like fantasy when the government is now spending much of its $500bn in currency reserves to bail out overextended Oligarchs who face margin calls against their shareholdings in resource stocks. In July the head of Gazprom predicted $250 oil within a year, which probably reflected official thinking (and the investment bubble inflated by Goldman Sachs and others). At sub $70 oil, the Russian budget is in deficit and Gazprom is facing a funding crisis; as a high cost producer, many new Russian energy projects will be put on hold. Meanwhile, the IMF, after years of irrelevance, has suddenly had to provide emergency loans to countries from Pakistan (which like Mexico, is a geopolitical nightmare in the making) to Ukraine.

Having more than halved in a few months, what now for emerging markets?

After massive capital flight, as foreign investors fled what turned out to be momentum trades hugely correlated with the bubble in commodities, earnings based equity valuations are now about 7.5x trailing P/E and 1,200 bps equity risk premium. However, the Price/Book multiple (1.2x) is still some 20% above the Sep 98 trough.

Technically, MSCI Emerging Markets Index is over 3 Standard Deviations below the 200 day moving average, the most oversold market in the history of the asset class. Emerging markets are discounting a more than 50% decline in EPS (vs the 67% decline in 1997/8); EPS is still growing at 16% currently, and that will decline to maybe 5% in 2009 (against almost certainly a big minus in the US and Europe).

Right now, if we get a sustained global bear rally into the year end (from lower levels I'd expect, I'm still net short), and a part reversal in the dollar squeeze, I'd look to play those emerging markets that benefit from declining commodity prices by seeing their terms of trade improve; one of the key triggers of the collapse in these markets was surging inflation in the first half (which I warned about several times on this blog), and rate hikes to belatedly tackle it. China and India look best placed from this perspective to expand monetary policy and enjoy a current account windfall from tumbling raw material import prices.

Medium term, the demographic profile and resource wealth of the emerging markets will make them a very attractive asset class again, particularly given the long period of stagnation the developed world now faces in the wake of the historic collapse in credit markets.

Disclosure: none

Comments

[cbellison:]

thought I would point out that it isn't true that Jim Rogers was recommending emerging markets "right up until the crash." Rogers is on record saying that he sold out of all emerging markets except China. I'm sure a bit of research would confirm this. Otherwise, a good piece.

2008 Oct 24 01:24 PM