Emerging market resilience faces critical test

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.

"With S&P .SPX flat on the year and emerging (equities) up 30 percent, you can't say there is no decoupling," said Shanat Patel, global emerging markets strategist at Nomura. "The picture has changed since the last U.S. recession, Asia is now a creditor which was not the case last time the U.S. slowed."

And valuations do not seem overly rich -- the forward price/earnings multiple on emerging equities is around 16 compared with 15 for developed world stocks.

Sam Mahtani, a fund manager with F&C that runs $6 billion in emerging markets, says the process is underway but may be slow.

“Decoupling will happen over three to five years. We are possibly very early on in that process,” he said.

WHICH ONES?

But all emerging markets are not equal. In giants like India and China, with huge infrastructure projects, growth has taken on a momentum of its own, independent of the United States.

“If there is a big U.S. slowdown and weaker flow of capital to emerging markets it will be a story of relative value depending on growth dynamics,” said Lehman Brothers economist Silja Sepping. “You go for countries with good domestic demand and that’s what people are clearly already trading.”

She notes for instance, investors in eastern Europe are already shunning export-reliant Hungary with its 1 percent growth in favor of the strongly growing Poland and the Czech Republic.

And India and Indonesia, where exports account for 23 and 30 percent of GDP, will likely outperform South Korea and Taiwan where the ratio is 47 percent and 73 percent respectively.

The problem is emerging markets overall are still largely prone to risk sentiment. Without the abundant liquidity flows of past years, they will find it harder to enact key reforms.

Some like Goldman Sachs see this year’s decoupling in effect as a split between the United States and the rest of the world.

A mere slowdown, confined to the United States, would keep appetite solid for emerging markets, the bank said, but warned:

“In a more bearish scenario, the U.S. moves closer to a recession and the rest of the world slows considerably. In that case emerging markets would likely underperform non-dollar majors on back of higher risk aversion.”