Emerging markets present opportunities, even though they are as beset by Europe as the rest of the world and have additional problems of their own. Sensitivity to Europe is hardly surprising.
Beyond the great cloud of uncertainly rising from the old continent, China, in particular, depends on Europe as a market for its exports, and many other emerging economies depend on China as a market. Still, for all the legitimate concerns, matters looking into the second half of 2012 should face much less adverse pressure than during the last 12 to 24 months.
Like all equity markets, emerging equity markets have performed poorly since spring. Perhaps even more unsettling to investors is the degree of correlation among all markets. Whereas seven to 10 years ago, emerging markets had only a 40% to 50% correlation with developed markets, since 2008 they have shown correlations of closer to 85% to 90%. Thus, as American and other developed markets began their recent, uneven decline this past spring, emerging markets followed. China's Shanghai Composite Index, for example, fell about 8% to mid-year from its highs of early spring. Brazil's Bovespa Stock Index did even worse, falling some 15% during that time, and India's SENSEX Index, though it moved off its lows in June, still showed a drop of approximately 9%. Currency declines compounded the losses to emerging market investors. Brazil's real lost about 15% of its value against the dollar during those months, and India's rupee lost 14%. China's yuan, which faces considerable diplomatic pressure to appreciate, gave up about 1.0% of its dollar value.
High market correlations will likely persist in a world responding more to global macro developments, such as Europe's crisis, then to company, sector, or even national problems. Still, there can be no denying the good value now present in emerging equity markets. Price-to-earnings and price-to-book multiples across most of these markets—except in this past year's stellar performer, Indonesia—remain well below their long-term averages, not far, in fact, to their 2008 lows. Though emerging market valuations almost always run leaner than those in developed markets, today that difference is appealingly wide. Of course the composite of the whole emerging sector has seen its average valuation dragged down particularly by emerging Europe, which is especially dependent on troubled Western Europe. But even in China, Asia generally, and Latin America, current relative value measures lie in the middle of the historic band or well toward its cheaper, attractive side.
If these economies disappoint, of course, even cheap valuations will offer little protection, but since pricing now already reflects a very negative outlook, the room for such disappointment seems pretty limited. Of course, country by country assessments differ. The term "emerging markets" refers to what is in reality a remarkably diverse group. Each national economy and market has its particulars. Indian prospects, for instance, depend on an incredibly complex blend of economic and political considerations. But in many respects China is indicative and besides, as the largest emerging market, it has the ability to impact most of the rest significantly.
China's economic prospects have suffered from three adverse influences. One, of course, is Europe's debt crisis and that continent's attendant recession. The European Union (EU) is the single largest market for Chinese exports, and exports are the single biggest growth driver in that economy. With Europe's recession deepening, and little chance any time soon of a grand solution to the debt pressure, there is little hope for relief on this front, though any viable rescue mechanism, especially if the European Central Bank (ECB) makes its immense financial resources available, could lift spirits and valuations in all markets and economies, including China and other emerging markets.
But if Europe will remain a source of weakness, the force of China's other two growth retardants—the legacy of last year's monetary restraint and China's burst housing bubble—should abate.
Last year, Beijing put on the policy brakes. Fearing a rise in inflation toward 8% or more a year, it engaged in a major monetary tightening. The People's Bank of China (PBC) in 2011 drained liquidity from Chinese markets by raising the percent of reserves banks had to hold against their loans and deposits and by raising target interest rates—both several times. The economy still labors under the lingering effects of that restraint. But things are changing. With inflation back down to the much more acceptable 3% annual rate, Beijing has begun to reverse last year's policy. The PBC has recently cut its benchmark interest rate and reduced the reserves required of banks. Pessimists worried when lending failed to pick up immediately after the monetary easing started. They feared a "liquidity trap" in which monetary ease loses its economic effect. But such fears were likely misplaced. Not only is there always a lag from a policy shift to its economic effect, but even as early as May, lending began to pick up, rising 793 billion yuan ($125.6 billion) that month; 16% above April levels.
Similarly, there is reason to look for an easing of China's housing problem. To be sure, the building and debt excesses of past years will continue to hold back China's economy. But it would be a mistake to draw, as too many Westerners do, a parallel between China's and America's real estate bubbles. China may have problems, but they pale by comparison. For one, Chinese house buyers are not nearly as leveraged as were Americans. By law in China people must put down at least 20% of the property's cost on their first house and at least 50% on their second. Few in China find themselves "under water" on their mortgages. China's debt burden lies largely with local governments. And, though hardly something welcome, such debt is a lot easier for Beijing to cope with than the widespread sub-prime debt was for Washington. What is more, China should work off its excessive housing inventory far faster than the U.S. There are, after all, 11 million marriages a year in China and some 10 million to 12 million people a year migrate from the countryside into China's cities. It also is clear that many Chinese have begun to take advantage of now reduced mortgage rates, especially discounts of 15% for first-time homebuyers. Major cities already report increased transactions. Though housing prices are down 25% from their peak of a couple of years ago, recent month-to-month figures show relative pricing stability.
Meanwhile, the government in Beijing has enhanced growth prospects with an added fiscal push. Certainly China, unlike most developed economies, has ample room to pursue fiscal stimulus. Public debt outstanding amounts to a mere 25% of the country's GDP.
Beijing, worried over speculation, has moved more cautiously than it did with its huge 2008 stimulus. But still the government has done much: streamlined approvals for new business development and offered tax breaks for businesses; fast-tracked some 66 billion yuan ($10.5 billion) of infrastructure projects, including huge investments in three steel plants, hydropower plants, and airports; increased finance for 2.3 million additional public housing rental units; and provided 36 billion yuan ($5.7 billion) in subsidies for the purchase of energy-saving household appliances. Since China's households save at a rate of 51% of their disposable income, they surely can take advantage of such largess.
It would strain credulity to suggest that such efforts can allow China to reach its old 10% to 12% yearly real growth rate. China's need for fundamental, longer-term adjustments, away from export dependence and toward broad domestic development, will keep growth slower than in the past. But matters look poised to allow China to meet its 7.5% real annual growth target. That alone should provide some relief given today's depressed pricing. Such growth should also help lift many of the other emerging economies that depend on China, Brazil, and other more purely commodity-dependent economies. The picture, though far from robust, is better than the expectations implicit in today's pricing.
Milton Ezrati is Senior Economist and Market Strategist
for Lord, Abbett & Co. and an associate of the Center for the Study
of Human Capital at the State University of New York at Buffalo.
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