Decoupling: are emerging markets breaking up with developed economies?

Emerging markets have suffered greater falls than traditional markets in the past six months, which nobody predicted.

The talk last year was that any downturn in the US would have minimal impact on emerging markets, but the reverse has turned out to be true.

However, emerging market managers haven’t viewed the first quarter performance as negative.

HSBC Investments global head of emerging markets business Christian Deseglise said the underperformance of the sector in the first quarter of this year was not huge when considering where returns had been.

“When you look at countries such as China, they had become too expensive,” Deseglise told Money Management from New York.

“But the economies of emerging markets are still performing and we are seeing some signs of decoupling from traditional markets, especially during April and May.”

He said arguing against the attraction of strong economic growth in the BRIC (Brazil, Russia, India and China) economies was difficult.

“There has been real structural decoupling in various emerging market countries,” Deseglise said.

“I am convinced of the structural decoupling argument, but in areas such as Eastern Europe it will take some time.”

According to Aberdeen Asset Management associate director Stuart James, Asia was the hardest hit region during the recent period of global stock market volatility.

“Emerging markets have had a very poor first quarter this year,” he said.

“They are some of the worse performing equity markets, with Asia down about 15 per cent compared to the US, which is only down 10 per cent.”

“People simply moved funds out of Asia back to the US in the first quarter,” James said.

He said sub-prime was purely a US and European problem, yet the markets reflected the opposite.

“A disconnect between where the problems were based and where the cash is held doesn’t show up when looking at the returns,” he said.

“The decoupling of emerging markets from the US, which everybody was predicting, hasn’t happened.

“But the emerging markets story hasn’t changed; they still have strong cash reserves, consumer spending is growing and they have been bailing out troubled US banks.”

Olympus Funds Management chief executive officer John Pereira believes the sell down of emerging markets has been too dramatic.

“These markets have had a rough time this year and to a large extent they have been oversold, despite the need for some sort of correction,” he said.

“But there has been some improvement in returns during the past couple of months.”

Pereira said the correction has generated good value and institutional investors in China and India were poised to come back into the market.

“The fundamentals haven’t changed and in India the strong economic growth remains intact,” he said.

“And we are seeing strong GDP [gross domestic growth] growth going forward as India only fell 0.8 per cent during the last quarter to 8 per cent.”

In a presentation to institutional investors in London last month, Schroder Investment Management predicted a 15 to 20 per cent return for emerging markets next year.

This strong prediction for continued growth in emerging markets is based on the fact they have grown 4 per cent faster than traditional markets every year since 1999.

This is underpinned by strong GDP growth for emerging countries, according to Schroders.

Latin America is predicted to deliver 4.1 per cent GDP growth in 2009; north-east Asia 7.9 per cent; south-east Asia 5.8 per cent and Eastern Europe 5.9 per cent.

This compares to forecast GDP growth in the US of 2.3 per cent and Europe 2 per cent.

This growth should not be affected by sub-prime problems, as emerging markets have low levels of financial sophistication.

James said the global problem is sub-prime mortgages that ended up in fixed interest products, but Asian, Middle East and Latin American countries do not have a sophisticated mortgage market.

“Asia has never had the sub-prime model, it was the US and Europe,” he said.

“As a result, I think emerging markets have been over-sold.”

However, a correction in emerging markets was due as the performance figures had been spectacular up to the end of 2007.

“The hype got ahead of the fundamentals,” James said.

“The pull-back in emerging market returns has been healthy in the long-term and will avoid bubbles being formed.”

He said there was now fairer value in emerging markets and the fundamentals show the overall market is still healthy.

“Everybody was due for a correction, but the Asian sell-off has been out of sync.”

An example is India, where five-year returns were 400 per cent, but even with the dreadful March quarter, returns have only dropped 20 per cent, according to James.

“There are still opportunities in Asia for the long-term investor,” he said.

“Nothing has changed, as the crisis was in developed markets.”

Another factor in decoupling is that emerging markets are exporting more goods to other emerging markets, and especially to China.

According to HSBC, China is now sourcing oil from Angola, Chad, Nigeria and Sudan, base metals from Argentina, Brazil, Congo and South Africa and cotton from Mali.

“Emerging countries are depending less on the US to export to, although it is still an important economy and hard to ignore,” Deseglise said.

According to Schroders, in 2007 China sold almost $US250 billion of exports to the European Union compared to $US240 billion to the US.

This is the first time exports to Europe have overtaken the US.

At the start of this year, Chinese exports to emerging markets were almost 48 per cent while exports to G7 countries had fallen to less than 40 per cent.

But emerging markets are not free of problems and, as in the developed world, inflation is lurking. This is being driven by consumer demand, especially in countries such as China and India.

However, Deseglise said the strong economies and growing reserves mean these countries are better placed to deal with problems such as inflation.

“The macro economies of emerging markets are much stronger than they were 20 or 30 years ago,” he said.

“And the reserves are there to allow greater decoupling from traditional markets such as the US.”

The reserves of emerging markets have generally escaped the sub-prime meltdown because of the low penetration of mortgages and credit cards.

“Emerging markets have US$5 trillion of reserves,” Deseglise said.

The young aspiring population of both China and India is continuing to drive growth, according to Pereira.

“Consumer demand in these countries hasn’t changed and will continue to drive GDP growth,” he said.

“Like all emerging markets there will be bumpy periods, but the growth story hasn’t changed.”

Another dark cloud on the horizon is food prices, which are affecting a number of emerging countries.

“When people become richer they change their eating habits,” Deseglise said.

“Food costs are creating stress in many countries and it is a worry for central banks.

“Rising food costs are also pushing up inflation and a tightening in monetary policy could create a cyclical downturn.

“This is one risk we will have to monitor very carefully,” Deseglise said.

“There is no G7 in emerging markets to monitor monetary policy.”

James agrees rising food prices are a concern, especially in Asia.

“In Asia, food is a higher proportion of income compared to that in the US,” he said.

Aberdeen is still bullish on the outlook for emerging markets, although it accepts there will be some pain in the short term.

“The story hasn’t changed and emerging markets are becoming increasingly important in the global economic world,” James said.

“The money is still in emerging markets and the economies are strong.”