Emerging markets bounce back

After a strong start to the year, emerging market equities were hit hard by the market correction in May and June. However, they have since recovered and should continue to perform next year.

In 2006, emerging market equities look set to outperform developed market equities for the fifth year in a row. The year started strong, with the riskiest markets and commodity exporters performing the best. In March, the first signs of reduced risk appetite appeared in high carry-trade markets such as Iceland and Turkey.

Two months later, emerging markets fell across the board when disappointing inflation numbers in America heightened fears about rising interest rates. Not only did equity and fixed income markets drop sharply but the currency markets also saw heavy selling. Countries with large current account deficits -Turkey, Hungary, South Africa and Indiasuffered the most. Exchange rates shed more than 20%, forcing central banks to raise interest rates by much more than had been expected.

As a result, the prospects for economic and earnings growth deteriorated, which triggered another sharp decline in emerging market equities in early June. From mid-June onwards, the asset class recovered on the back of strong global liquidity growth and resilient commodity prices.

In August, risky assets suffered a slight setback when market participants saw increased risks of a full-blown American recession. But from October onwards, emerging markets steadily outperformed developed markets again. Most recently, the most important driver has been improving American interest rate expectations for 2007.

The May/June slide was triggered by fears of American rate hikes in combination with uncertainties about yen carry trades. Looking back, we can see clearly that the turbulence was a cyclical correction, coinciding with a peak in global leading indicators.

Emerging equities tend to suffer when expectations for global growth are at a high. This is the time when downside risk is the largest and profits are taken most aggressively. Preparing for a cyclical correction is not easy, but not impossible either. Early in 2006 we expected the cyclical peak to be in June or July after adding the average length of a cyclical upturn to the trough in leading indicators in 2005. It turned out that the peak came a month earlier, in May.

But it was soon clear that the surprisingly sharp downturn was a cyclical correction. Smart investors quickly reduced portfolio risk, limiting the damage effectively.

In the turbulence, it made sense to reduce cyclical exposure by selling South Korea, the largest market in the global emerging markets universe. Since then, it has been reasonable to keep a large underweight in those markets that are geared the most to global growth expectations, on the view that leading indicators will continue to trend down well into 2007. With Chinese economic growth remaining solid and global liquidity growth still accelerating, the exposure to riskier markets and commodity-exporting countries can, however, be increased.

The best-performing markets have been Indonesia and China, while the worst performers have been Turkey and Israel. Indonesia is benefiting from falling local interest rates and rising raw material prices. The equity market, which has been pricing in the improving growth prospects gradually, has outperformed the global emerging markets index by 37 percentage points so far this year.

The Chinese market has outperformed global emerging markets by 30 points. The outlook for Chinese growth is rosier than that for the global economy and valuations are more attractive. With concerns about the American economy intensifying, and domestic demand in China showing more signs of autonomous growth, global investors have increasingly moved money into Chinese equities.

It is remarkable that Turkey and Israel are both among the laggards. Turkey is our riskiest market, while Israel is one of the most defensive. Over the year as a whole, risky markets have done well. This is why Israel has been underperforming. Domestic factors have caused the Turkish market to underperform, outweighing the availability of risk capital for countries with high external financing needs. A rapidly widening current account deficit, despite interest rates of 20%, and growing political risk are the culprits.

For 2007, the prospects for emerging equities are good, mainly because of spreading globalisation, strong global liquidity growth, expectations for improving interest rates and the likelihood of solid commodity prices. The markets that should perform well are the ones where rates can fall the most – Brazil, Indonesia, the Philippines and South Africa – where high raw material prices are fuelling domestic liquidity and credit growth – Brazil, Indonesia, South Africa and Colombia – and where workers’ remittances are pushing up consumer demand – the Philippines and Indonesia.

Towards the end of the second quarter, we expect a trough to have been reached in global leading indicators. From then, emerging markets are likely to benefit from strong cyclical tailwinds. The markets that should gain in attractiveness then are Korea and Taiwan.