Will Emerging Markets Escape the Global Downturn? Part I - Bearish

 |  Includes: BIK, EEM
by: HiddenLevers

by Yann Toullec

Monday’s slump in emerging markets stocks was just a warning. After weeks of overheating, investors are just starting to realize that the ongoing Greek Tragedy (no pun intended) will be felt way beyond the eurozone, and that emerging economies are not strong enough to escape this global downturn.

The past days have given some clear signals of weakness. As pointed out by analyst Louise Yamada, some emerging markets have been flat up to two years, underperforming most developed markets. Moreover, the lingering concerns about the ability of China and Brazil to fight inflation lead me to believe that the BRICS still don’t have the fundamentals to face external shocks, and that emerging markets will suffer a severe correction over the coming months.

As for those who think that those risks are not unique to emerging markets, I would argue that EM stocks have historically shown a much stronger sensitivity to global downturns. Their high susceptibility to volatility is a well-known fact, and as the fear of a Eurozone contagion is gaining across stock markets, strong exposure to EM stocks can be dangerous. To visualize this trend, I have used the HiddenLevers charting tool to compare two major Emerging Markets ETFs-- the iShares MSCI EM Index ETD (NYSEARCA:EEM) and the SPDR S&P BRIC 40 Index ETF (NYSEARCA:BIK)-- against the VIX, which gives an estimate of the stock market’s volatility.

Chart created using Hidden Levers app

Aside from the obvious inverse correlation between volatility and the two EM ETFs, this chart also tells us that in 2010, it took about 6 months for emerging markets to fully recover from the first Greek bailout in April. And given the bad turn this year’s euro-drama is taking (Italy’s debt downgrade, Ireland and Portugal still queuing up in the bailout line, Spain stuck with structural reforms, etc.), I believe emerging markets will suffer at least the same drop as last year.

Here is what a Eurozone collapse could look like:

Chart created using Hidden Levers app

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.