Emerging markets going cheap

by Levi Folk | June 21, 2008

Investors have been selling off their stock and fund holdings in emerging markets because of inflation fears, not because growth is slowing in these countries.

The MSCI China index is now off by a quarter in U.S. dollar terms and MSCI India index is off by more than a third.

Growth is indeed slowing in these countries, but index levels have been razed to the point that valuations are attractive for investors with three-to five-year time horizons. (Note: in the interest of full disclosure, I recently started covering emerging markets on behalf of Excel Funds.)

Expectations of a downturn in the U.S. economy last year were reason enough to lighten up on emerging market equities. Then I suggested that tighter liquidity and slower growth in the developing world would have knock-on effects on emerging markets. It was inflation that got emerging markets in the end.

The notion that emerging markets could decouple from developed markets appears only partially valid. Growth is slowing in emerging markets because central banks are being forced to contend with a major inflation problem through monetary tightening.

The inflation in food and energy prices has been caused by unflagging demand from the emerging markets—and exacerbated by exchange rate policies in the developing world aimed at maximizing growth and competitiveness. China, for example, has resisted appreciation in the yuan by printing money and buying U.S. dollars, US$1.3-trillion greenbacks in all.

This tonic has proved too strong and has been exacerbated by the fall in the U.S. dollar in recent months. Monetary policy in many emerging markets has been loosening in tandem with U.S. monetary policy as they pushed for higher growth. At the very least, central bankers should have parted ways with the U.S. Federal Reserve Bank last year when they put the U.S. economy (and U.S. financial sector) on monetary policy life support.

Since last summer, the Fed has cut rates to 2% to revive the economy. The intended consequence of that action is a weak currency. The unintended consequence has been even more inflation in food and energy prices, since commodities are priced in depreciating U.S. dollars.

Consumer price indexes in the emerging economies are more geared to food and energy inflation, so inflation is even a bigger threat to these markets. Food prices account for one third of China’s CPI, for example.

The Fed has been forced to verbally rescind its policy of aggressive monetary easing by talking tough recently on inflation. Bond investors have been impressed by the bravado and have priced in 50 basis points in Fed tightening by year’s end.

Rather than just talk tough on inflation, the Reserve Bank of India (RBI) and the People’s Bank of China (PBoC) are actually starting to get tougher on inflation.

The RBI hiked rates recently to 8% to rein in demand.

In China, the PBoC has been increasing reserve requirements to rein in lending.

Rising prices are admittedly a bigger problem in these countries. Inflation has risen at a 7.7% annual pace in China and at an 8.5% rate in India in May.

Unlike the Fed, central banks in India and China are merely bringing their respective economies off the boil.

Growth is slowing in many of the emerging markets, but from very heady rates. India’s economy grew by 8.4% in the fourth quarter of 2007 and China’s economy expanded by 10.6% in the first quarter of 2008, both at annual rates. This growth represents a slowdown from last year that is likely to continue through 2008.

Assuming inflation is met with appropriate policy responses—yuan appreciation in China and further rate hikes in India; both big ifs, since policy needs to tighten further still, as real interest rates remain negative in both China and India—then valuations are sufficiently low to warrant buying into these markets.

The MSCI China index is currently trading at 13.5 times 2009 earnings that are expected to grow 17% on 2008 levels.

In India, the broader Sensex index is trading at 12.2 times multiple on fiscal-year 2010 earnings, with an expected growth rate of 19%.

These multiples represent significant discounts from 2008 levels and, crucially, appealing entry points to two of the most promising economic prospects of the next decade.