Emerging Markets Unfairly Punished During Recent Volatility

Includes: EEM
by: Promod Radhakrishnan

It obviously has been a wild few weeks across pretty much all asset classes. A slim recovery that was taking hold in Q1 was washed away by a new round of credit-related worries in Europe and economic statistics in the US that were perceived as pointing to stalling of growth. As almost every trader or analyst has commented, this is not the best time to throw the hat in fully – yet.

However, if you are looking medium-to-long term, there are certain segments of the market that offer relatively good value. In my view, emerging markets got an unfair share of the thrashing this time around. In a completely sentiment- and fear-driven environment, gold and treasury securities have gained at the expense of US and European equities, but even more so at the expense of emerging market stocks.

Many of the larger emerging market nations have a big domestic market and are not solely dependent on exports for driving GDP growth. Let’s look at a true value of exports (net value added as against top line) as a percentage of national GDP; the number is below 25% for large emerging economies like China, India and Brazil. Thus, the impact of a marked slow down or even a mild recession in the developed countries should not be as catastrophic as many would have us believe.

Now let’s look at the MSCI Emerging Markets Index (NYSEARCA:EEM) -- the above three emerging economies account for 42% of the index weighting -- a good proxy for emerging markets performance. This index has dropped from 1158 on July 28 to 975 on July 26, a drop of 16%, as compared to a 10% drop for the DJIA and 20% for the Euro Stoxx (an indicator for the European markets, which have been the chief culprit for this round of market pull back). Thus, within the above time horizon, the implied correlation (by the stock markets) between growth prospects in emerging markets and that in developed nations is clearly much higher than warranted. One can argue that stock market movements do not necessarly reflect GDP growth prospects directly, but the correlation has to be meaningful at least in the medium-to-long term.

Now let's look at relative growth rates and current market valuations. Given the historical growth rate in emerging markets like China and India, it is difficult to imagine growth rates lower than 6-7% at the worst case, even with depressed conditions in the developed world. This is as compared to an estimated global growth rate in the mid-3s for 2012 and 2013 and below the 2s for the US and Europe. On the other hand, at the current valuations, you have the basket of emerging stocks available at a very attractive P/E of sub-12 as against a P/E of 13+ for a comparable global index.

Another point to note is that one of the key reasons for the beating taken by emerging market indices like India's has been the heavy reliance on foreign portfolio and direct investments. These are extremely fickle in nature and are very sentiment-driven in the short term. However, given the very fact that these are fickle, we should see significant net inflows once these markets report a couple of quarters of relatively robust GDP growth.

If you have a reasonably medium-to-long term horizon in emerging market stocks, I feel there is only a low probability of any substantial downside at this point. However, you need to pick ETFs or stocks pertaining to a China, India or Brazil against ones mapping to a Taiwan, Korea or Russia, given the relative dependence on exports for GDP growth.

Don't throw all your money in yet, since any flare-up in inflation, driven by a spurt in fuel prices or shortage in agri-commodities can significantly affect direction in these markets -- especially since interest rates are already pegged quite high.

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