Emerging Markets - Fundamental Weakness Remains

Includes: EEM, EWZ, INP
by: Promod Radhakrishnan

After a solid start to the year, indices across emerging markets saw a disastrous May, in line with other global market indices. Given that the steep dip in May was primarily driven by the crisis in Europe, would it be right to expect emerging markets to bounce back? Especially given the fact that valuations are near five year lows across the emerging markets regions, especially in BRIC countries?

To start with, take a look at the MSCI Emerging Markets Index. After a choppy Q4 2011, the MXEF ran all the way up from late December '11 900-levels to close to 1100 by late February and stayed along those levels till end April. The drastic dip in May has taken the index all the way down to 900, posting a 1 year drop of 18.5% and a YTD drop of close to 1%. The fact that valuations are at a 5-year low and the index is trading pretty much at pre-2010 levels gives some cause for optimism.

However, a look at country fundamentals does not leave a lot of room for optimism in the short-to-medium term.

China's economy is finally slowing down, albeit in a controlled manner, after over two decades of 9%+ growth. As Ruchir Sharma (MS Emerging Markets Fund honcho) opines, China is facing a similar situation like that of Japan, Korea and Taiwan all of which slowed down after multi-decade high-growth spurts. The reality is that sustaining close to double digit growth rates is a completely different ball game when you are a 5 trillion dollar economy as against the case when you are a sub-1 trillion dollar economy. Especially in a scenario where a large portion of its export markets are facing significant slow down. So, though quick policy measures will probably avert rapid stall, growth rates are bound to slow down and sustain at 6% levels or so.

India's situation is a bit worser since a steep fall in the Indian rupee vis-a-vis the US dollar has forced a drastic increase in fuel prices and this would eventually stoke wholesale and consumer price inflation. It is highly unlikely that the central government/RBI can control inflation to sub-7% levels unless there is sustained tightening of fiscal and monetary policies. Given the country's high reliance on imports (trade deficit hit an all-time high of $185 billion in 2011-12) & a slowing foreign portfolio investment scenario driven by 'risk-off' behavior, the pressure on the rupee would not ease significantly in the coming few months, unless a drastic improvement happens in global risk uptake driven by positive moves in Europe.

This, combined with sloppy government policies on foreign direct investment, (delay in easing FDI restrictions, retrospective tax charges like the one on Vodafone (NASDAQ:VOD) etc) will cause undue dependence on domestic consumption for fueling growth. Growth rates are bound to slow below 5% levels for 2012-13.

Though relatively better off, Brazil's economy is also expected to slow down to a 3-4% growth trend in 2012, as compared to the earlier expected close to 5% levels. Despite growing steadily to overtake Britain as the world's sixth largest economy, complex tax laws and a global economic slow down (especially in China, a key importer of its raw materials) will undoubtedly tighten the reins on economic growth this year.

Russia is also seeing signs of slow down, with GDP growth slowing down to 3.7% in April as compared to 4.9% estimated for the first quarter. Investment spending will slow down thanks to the euro area situation, and a slow down in China doesn't help Russian exports either. GDP growth is expected to probably taper off to mid 3% levels in 2012.

South Korea is probably the only country expected to continue its growth trend, with an over 3.5% growth rate expected in 2012 and an even higher rate in 2013. However, growth projections have been marked downwards as compared to last quarter, primarily driven by overall global economic slow down since its GDP is heavily reliant on exports.

Thus, it remains a wait-and-watch situation with no clear drivers pointing to an immediate uptick. A drastic move up or down in Europe could of course tilt the balance; however, medium term growth worries will persist. And in a global environment which would continue to favor a risk-off strategy in the near-to-medium term, portfolio investment moves would also possibly not favor the emerging markets segment.

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

Additional disclosure: I have no positions in ETFs tagged to Emerging Markets indices, nor do i intend to open one in the next 3 months.

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