Emerging Markets: Strong Economic Growth likely To Continue

On my vacation, we talked about the pullback in markets in reaction to fears that the central bank punch bowl will be drained sooner than some participants expected. I was particularly concerned about the accelerating sell-off by investors in emerging markets. This year had already been difficult for emerging markets. At the end of May, the widely held iShares MSCI Emerging Markets ETF, EEM, was down 3.3% year-to-date. At the close of business last Friday, June 21, EEM was down 15.65%.

A broad retreat from emerging markets in a general equity correction period of “risk off” is not unusual. The concern is whether this is just a market correction or a move to a longer-lasting bear market. Some of the markets that dropped the most, including the Philippines, Thailand, and Turkey, were the outperformers earlier, as might be expected. Some emerging markets are also being hit by political problems, such as Brazil and, again, Turkey. Several were not hit as hard in May and June – Malaysia and Poland among them.

Currently our emerging-market positions are all in the Asia-Pacific region. We had expected them to do well this year based on their relatively strong economies, reasonable valuations, and double-digit earnings-per-share growth projections. Relative to other emerging-market areas, the year-to-date 11.26% drop in the MSCI EM Far East Equity Index has been considerably less severe than the 16.21% decline in the MSCI EM Eastern Europe Index and the 20.52% decline in the MSCI EM Latin American Index.

Whether Asian emerging markets will outperform on the upside when the correction is over may well depend on China. As this note is being written, the sharp 6% drop in China’s markets last night is being blamed for further market declines around the globe. Investors appear to fear that the moderation in China’s economic growth, already evident in the first half, could become more severe. The apparent trigger for last night’s market swoon in China was official statements that, despite the cash crunch that has been evident in the financial system since early June, which caused short-term rates to surge late last week, there was “no shortage of funds in China’s financial system.” The trouble is just that the money is in "the wrong places.” It was made clear that a crackdown on “shadow financing” is underway.

China stocks have been hit by the tightening in China’s credit markets at a time when global markets are still reacting to concerns that the US Federal Reserve is going to reduce its injections of capital sooner than some expected. They also participated in the broad retreat from emerging markets that was underway before these developments. Despite the market reaction, we view the moves by the Chinese central bank, the People's Bank of China, as being good for the long-term sustainability of the Chinese economy. The Bank needed to let some air out of the credit-market bubble that was developing and to impose increased market discipline, particularly with regard to reckless lending through unregulated shadow financing. There is no overall shortage of funds, and the People's Bank is ready and able to provide liquidity to any banks experiencing funding problems, either directly or through larger banks.

The sharp market reaction reflects dual fears that economic growth will be impacted and that, while the objective is laudable, the Bank may not be able to prevent the credit constraints from escalating into a more serious credit crunch. That is indeed a risk, but one the Bank has the ability and resources to counter should it start to develop. My expectation is that any negative economic effects will be limited and transitory. Addressing financial problems now should be a medium- and longer-term positive for the economy and for China equities, particularly if accompanied by a continuation of the ongoing process to liberalize China’s financial markets and exchange controls, providing domestic Chinese investors with a greater range of investment alternatives.

In view of the current turmoil in China’s financial sector, long-term investors interested in using the current market pullback as a buying opportunity might wish to limit exposure to financial institutions at this time. In our International and Global Multi-Asset Class Portfolios, we presently hold PowerShares Golden Dragon China, PGJ, in which financials account for only 1.47% of total holdings, and Guggenheim China Small Cap, HAO, with a financials share of 2.48%.

As for other emerging markets going forward, we do not see the Bank of China moves as having any lasting negative implications. While China is not likely to return to the double-digit economic growth rates of the past, it should be able to maintain a very healthy 7-8% pace, which will be good for countries for which China is an important market, particularly commodity exporters. Emerging markets as a group will very likely continue to experience stronger economic growth than the advanced economies will. However, that will be in a global economy that is advancing at a slow 3-3.5% annual rate and with the prospect that the period of very low interest rates will be coming to an end. Equity market performance among emerging-market countries is likely to vary considerably, putting a premium on selectivity. As a group, developed-market equities look poised to continue to register stronger performance, particularly in the Japanese and US markets, with Europe also looking a little brighter.

BY Bill Witherell