Wednesday, July 2, 2008 4 comments ++[ CLICK TO COMMENT ]++

Emerging Markets Not So Emerging Anymore

UPDATE: Theodore corrected me with my misunderstanding of the Chinese currency devaluation. It did not happen in 1998 due to the Asian crisis; instead, it occurred in 1994 for largely internal problems.

The topic of the day seems to be the fact that the US markets have entered a bear market. This is especially true of the Dow, which has fallen below the unofficial bear market threshold of -20% from the peak. The S&P 500 is slightly under 20% right now. I suspect a lot of the big decline in the Dow in the last few days is due to GM, which according to some analysts is on the verge of bankruptcy if certain conditions aren't met (such as raising more capital or if the economy doesn't improve). For the year, the US markets are down around 13%. Here is how some select markets in other countries have performed (source: Dow Jones World Indexes):

Many had been bearish regarding the US markets over the last few years and the tide seems to be turning. The US market, although still negative, has been outperforming most other countries. If it weren't for the US$ decline against some currencies, some of the foreign markets would be far worse than what is shown (the chart shows results in US$ terms.) If there is a crisis in some emerging market (we haven't seen any big ones yet), it is also likely that capital will flee to safe havens such as the US.

The countries that have done well so far have been commodity producing countries such as Brazil and Canada. However, I am bearish on commodities (have been wrong for an year though) and if commodities ever correct, these countries are going to get whacked badly. The rosy picture that is seen, of positive current account deficits, strong government fiscal balances, and/or relatively decent economic growth, can easily dissapear if commodity prices tumble.

Two of the hottest markets over the last 5 years, China and India, are falling apart--at least if you look at the equity markets. The chart below plots the collapse of the Indian and Chinese stock markets in the last 6 months:

The stock markets were severely overvalued in India and China so some of the collapse was to be expected. The real question is about the rest of the economy, including, what I perceive as, overheated real estate in China, India, Hong Kong, and so forth.

India, in particular, seems to be facing all sorts of problems, including some serious economic problems as BusinessWeek recaps:

Just six months ago, India was looking good. Annual growth was 9%, corporate profits were surging 20%, the stock market had risen 50% in 2007, consumer demand was huge, local companies were making ambitious international acquisitions, and foreign investment was growing. Nothing, it seemed, could stop the forward march of this Asian nation.

But stop it has. In the past month, India has joined the list of the wounded. The country is reeling from 11.4% inflation, large government deficits, and rising interest rates. Foreign investment is fleeing, the rupee is falling, and the stock market is down over 40% from the year's highs. Most economic forecasts expect growth to slow to 7%—a big drop for a country that needs to accelerate growth, not reduce it. "India has gone from hero to zero in six months," says Andrew Holland, head of proprietary trading at Merrill Lynch India (MER) in Mumbai. Many in India worry that the country's hard-earned investment-grade rating will soon be lost and that the gilded growth story has come to an end.

This shouldn't be too surprising to anyone that has been reading The Economist, or some of the entries I have written in the past. Of all the emerging markets, India was always one of the most vulnerable in my eyes. On top of the potential for inflation due to government policy, India was running a current account deficit and a big budget deficit. In contrast, many emerging markets, including China, are running a current account surplus. But current account surplus can be a double-edged sword and some of those countries are printing a lot of local currency to swap them for the incoming US$ (or whatever else). On the positive for India (a minor positive), it is not export-oriented so a slowdown in other countries won't impact it as much.

As for China, the situation looks decent but it's hard to say due to a totalitarian government running things. On top of the likelihood of cooking the books more easily (there is only one state-controlled media in most parts of China), state planners have not had to face a recession or any noticeable slowdown for almost a decade. China was hit badly during the 1998 meltdown but it wasn't as dependent on foreign exports back then (update: deleted incorrect statement about China devaluing the currency after the Asian crisis. China devalued the currency in 1994 for other reasons). Right now the problems are the opposite, with inflation starting to rise, and if they re-value their currency upwards, it can bankrupt a lot of manufacturers.

In any case, if one of you is bullish on China and India (and think the current corrections are temporary), now is the time to start doing some research. The equity markets in those countries have been overvalued for years but by the end of this year or next year, they may reach reasonable valuations. It's still almost impossible for foreigners to invest in China or India directly but the governments may relax capital controls if they run into economic problems and feel that foreign capital is needed.

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4 Response to Emerging Markets Not So Emerging Anymore

July 2, 2008 at 9:21 PM
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July 2, 2008 at 9:22 PM

Great blog, you have some excellent posts!

A couple of issues:
China did not adjust the RMB after the Asian Financial Crisis in 1997-1998, they devalued the RMB in 1994 under very different circumstances - essentially a domestic credit bubble.

The recent market pullback in HK has created some tremendous bargains, especially in the small-cap space, and if you run some screens, you'll be quite surprised to find a significant number of companies trading at huge discounts to liquidation value and at 2-3x earnings with insiders buying back stock hand over fist.

In terms of real estate being overvalued, on a private basis that may be the case (e.g. if you go out and buy a building), but if you look at public equities, you have implied cap rates well in excess of 12%.

July 3, 2008 at 11:39 AM

Thanks for correcting me Theodore. I mistakenly thought that the devaluation was due to the Asian crisis but it looks like I was wrong big time. I just quickly Googled for some articles and it seems that the fact that China did not devalue during the Asian crisis actually helped the situation from deteriorating further. Thanks for correcting me...

As for HK, I don't put much emphasis on insider buys or sales and I'm not sure if the 2x to 3x earnings multiple is due to peak earnings. I have to look into it deeper.

What are your thoughts on China post-Olympics? Some speculate that things may deteriorate after the Olympics. I don't invest based on speculation but inflation is starting to be a problem everywhere...

July 4, 2008 at 1:32 AM

Hi Sivaram,
You're correct, a lot of people have been predicting a bust after the Olympics because the economy is driven by heavy fixed asset investment, but the valuations in the Mainland are very different from HK, especially in the small-cap space, where you have so many stocks hitting 3 to 5-yr lows.

Keep up the posting!


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