Emerging-market stocks have more upside, but in need of correction

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In past articles I referred to the relationship between the MSCI Emerging Market Index expressed in Swiss francs and China’s CFLP Manufacturing PMI. By using arguably one of the world’s only non-fiat currencies the influence of currency movements on the MSCI Emerging Market Index is minimized.

The graph below illustrates just how out of line and inexpensive emerging-market equities were compared to the state of the world’s growth locomotive in the latter half of 2011 as the Eurozone debt crisis spooked investors. The market returned to rationality as the crisis eased in recent months, with the MSCI Emerging Market Index in line with February’s PMI of 51.0.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

But where to from here?

After collapsing to 48.3 in November last year my seasonally adjusted CFLP Manufacturing PMI for China increased for the third consecutive month to 51.9 in February, with the drop in the reserve requirement rate (RRR) of Chinese banks filtering through to the economy. As the global economy is not out of the woods yet, the further cut in the RRR in February is likely to lend additional support to the seasonally adjusted PMI and therefore China’s economy in coming months.

Sources: CFLP; Li & Fung; NBSC; Plexus Holdings.

After being held in check by the Golden Week celebrations of China’s lunar New Year from the second half of January through mid-February, the unadjusted CFLP Manufacturing PMI is likely to receive a significant seasonal boost in March and April.

Sources: CFLP; Li & Fung; Plexus Holdings.

I therefore argue that the MSCI Emerging Market Index in terms of Swiss francs is likely to be underscored by the expected seasonal strength in the unadjusted PMI, as well as the acceleration in growth as reflected in the seasonally adjusted PMI, on the back of the reduced RRR of Chinese banks.

In a previous note I pointed out that changes in the direction of China’s banks’ RRR were soon followed by directional changes in the Shanghai Composite Index. In the following graph the cumulative change in the RRR was quantified where a 0.5% change in RRR amounts to approximately US$60 billion. When depicted against the MSCI Emerging Market Index in Swiss francs it is evident that changes in direction in the RRR are followed by major changes in direction of the MSCI Emerging Market Index in CHF. The cuts in the RRR in the last quarter of 2008 were followed by a bottom in the MSCI Emerging Market Index in the first quarter of 2009. The hike in the RRR in the first quarter of 2010 was initially followed by the topping out of emerging-market equities, while further increases led to a slump in equity prices. Although equity prices showed an improvement at the start of the fourth quarter last year the cut in the RRR pulled equity prices out of the doldrums.

Sources: NBSC; I-Net Bridge; Plexus Holdings.

The MSCI Emerging Market Index has significantly outperformed the MSCI World Index since December last year and is currently in line with China’s unadjusted CFLP Manufacturing PMI.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The Shanghai Composite Index in terms of U.S. dollars relative to the S&P 500 Index has moved completely out of line with the unadjusted CFLP Manufacturing PMI, though.

Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Holdings.

The appearance of another black swan will alter my view but as things are I am of the opinion that the rally in emerging-market equities is likely to continue over the next few months. That said, the market has had a huge run and, being overbought, it is in desperate need of consolidation or even a major correction. I continue to favor the Chinese stock market above other emerging markets and developed markets.

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