Emerging market resilience faces critical test

By Sujata Rao - Analysis

LONDON (Reuters) - Cash in now or wait? Investors in emerging equities, which had been on a tearaway run this turbulent year, now face just such a dilemma amid signs a possible U.S. recession may hit harder than first thought.

Confident commentary about emerging markets' resilience to a U.S. recession is being replaced by nervous re-examination of the so-called 'decoupling theory'. November saw emerging equities lose 15 percent after rising 45 percent year-to-date.

Many subscribe to the theory that world economic growth will increasingly be led by emerging markets and will therefore not be too badly affected even by a full-blown U.S. recession. Rising emerging powerhouses, led by China and India, the argument goes, can pick up a lot of the slack.

But wary investors are unwilling to put this to the test.

MSCI emerging stock index has underperformed the MSCI World this month. Some especially cyclical markets like South Korea lost more, falling 8 percent last week versus 4.5 percent for the broader emerging index.

"Talk of recession in the U.S. economy has increased lately so the story of decoupling from the U.S. economy is being looked at more closely...this may be causing the latest bout of nervousness," said Christian Deseglise, who overseas $85 billion in global emerging markets business at HSBC Asset Management.

Emerging markets recovered quickly from an unfounded U.S. recession scare in February, receiving tens of billions of dollars all summer and autumn from investors who were fleeing subprime-exposed U.S. and Western European stocks.

That led many to term emerging markets the new safe-haven -- a term Deseglise says is not justified yet. Developing nations are less dependant on the U.S. market, but it still takes in over 16 percent of their goods and services, he notes.

This is down from a 25 percent share in 2001.

"Emerging markets don't need a fast-growing U.S. economy but they still need a growing U.S. economy....The U.S. remains a very significant customer," he said. "The risk is if there is a recession, it's likely the impact will overshoot just because everyone is saying the U.S. economy is not important any more."

LOGICAL DECOUPLING?

Looking at economic fundamentals alone, there is clearly a temptation to dub emerging markets the new safe haven.

Their share of the world economy is up to 30 percent from 20 percent in 1999 and growth rates are twice the average of the developed world. In contrast to advanced peers, most emerging nations run balanced or surplus budgets and current accounts.

And trade between emerging nations now exceeds exports to developed countries while emerging corporates tend to be less leveraged and have better earnings prospects.

That is why some believe the recent weakness is a natural fallout of the enormous bull run seen in prior months.