Is risk in emerging economies less than developed economies?

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To get an overall view of the health of emerging-market economies I developed a GDP-weighted manufacturing PMI as well as a GDP-weighted non-manufacturing/services PMI index using 2010’s GDP converted to U.S. dollars.

Following a double-dip in September and November last year, growth in manufacturing is steadily increasing, with the manufacturing PMI in February rising to 52.0. The PMI is still significantly below the recent peak of 54.3 in January last year.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management.

In the first half of last year growth in the manufacturing sector of emerging economies was significantly slower than that of the major developed economies. The sovereign debt crisis in the Eurozone leveled the score in the second half, though.

Sources: Markit; HSBC; CFLP; Kagiso; ISM; Plexus Asset Management.

With a weight of 51.9% China’s manufacturing sector has a major bearing on the emerging economies’ manufacturing PMI. Nowadays it is popular to say that when China sneezes the other the emerging-market economies catch a cold – yes, the same adage used for the U.S. in the past. My analysis indicates it is devoid of any truth. It is evident that the trend of my cyclically adjusted China CFLP Manufacturing PMI is out of sync with the GDP-weighted Manufacturing PMI of the emerging economies excluding China. The gradual weakening of China’s PMI from October 2010 to February 2011 had no effect on the rest of the emerging economies as the latter’s PMI continued to rise until Japan’s terrible twin disasters in March. The Manufacturing PMI (excluding China) bottomed in September last year while China’s PMI only bottomed in November, but the two series are now rising in unison.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management.

The GDP-weighted PMI (excluding China) is highly correlated with the GDP-weighted Manufacturing PMI that I calculate for the major developed economies.

Sources: Markit; HSBC; CFLP; Kagiso; ISM; Plexus Asset Management.

Due to limited data, I was forced to focus on the BRIC countries when calculating the non-manufacturing/services PMI for emerging economies. Contrary to the manufacturing PMI the non-manufacturing/services PMI of the BRICs remained well above 50 at the height of the Eurozone crisis and in February regained pre-crisis levels.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management.

It is noteworthy that while the services sector in the developed economies collectively was severely affected by Japan’s twin disasters the services sector in the BRIC zone was largely unaffected. It was only when the Eurozone crisis deepened that significant weakness appeared in the BRIC services sector. This sector also led the recovery as the crisis started to dissipate.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management.

China’s non-manufacturing sector that comprises 44.7% of the BRIC zone’s non-manufacturing/services PMI initially held up extremely well relative to the other BRIC economies when the Eurozone crisis hit the headlines, but in the end succumbed when the crisis deepened. The drop in China’s PMI in February last year can be ascribed to the later than normal Chinese Lunar New Year.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management.

It is also interesting to note that growth in the services sector of the BRIC zone is very steady compared to that of the developed economies – even with the stalwart China excluded.

Sources: Markit; HSBC; CFLP; Kagiso; Plexus Asset Management

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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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James Paulsen likes emerging-market stocks on interest rates

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James Paulsen, chief investment strategist at Wells Capital Management, talks about the outlook for emerging-market economies and stocks. He also discusses his strategy for U.S. equities.

Source: Bloomberg, November 7, 2011.

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Emerging markets are undervalued

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Investors in emerging markets have had a difficult year in 2011 and analysts are expecting them to underperform the developed world in 2012 in spite of the European crisis and sluggish growth in the US. Jonathan Garner, Morgan Stanley’s Chief Asia and Emerging Markets Strategist, says that scares over a hard landing for the Chinese economy and fallout from Europe mean valuations are now cheap.

Please click here or on the image below to watch the video.

Source: Josh Noble, Financial Times, November 2, 2011.

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Is derating of emerging-market stocks justified?

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The dividend yield of the iShares MSCI Emerging Markets Index Fund (EEM) recently moved above the dividend yield of the iShares S&P 500 Index Fund (IVV) for the first time since the 2008/2009 financial crisis.

Sources: iShares; Plexus Asset Management.

Sources: iShares; Plexus Asset Management.

The 76% increase in the dividend from EEM for the six months to June put the fund’s dividend yield on par with that of the IVV, but the continued market turmoil resulted in emerging-market equities significantly underperforming the S&P 500 Index.

Sources: iShares; Plexus Asset Management.

The sell-off resulted in the ratio of the dividend yield of the EEM relative to that of the IVV lingering close to the peaks that prevailed during the 2008/2009 crisis.

Sources: iShares; Plexus Asset Management.

The severe underperformance of the EEM in 2008 was justified as dividends were slashed by 30% over the following 12 months.

Sources: iShares; Plexus Asset Management.

By comparing the EEM’s underperformance against the IVV this time round, it seems that the markets are anticipating a cut of the same proportion over the next 12 months.

Sources: iShares; Plexus Asset Management.

Is the cold shoulder the market is giving emerging-market equities justified at this stage? I would say not. During the 2008/09 crisis the emerging-market currency I derived at by dividing the MSCI Emerging Market Index in US dollar by the MSCI Emerging Market Index in local currency terms fell by 22% and therefore contributed to the bulk of the slash in dividends. This time round the same MSCI Emerging Market Currency Index fell by only 7%. I am not professing that further depreciation is not on the cards. What I am saying is that given the current state of affairs the significant derating of emerging-market equities is not justified in light of dividend expectations.

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Is emerging market growth at risk?

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This post is a guest contribution by Manoj Pradhan of Morgan Stanley.

EM risky assets and currencies saw a sharp sell-off over the last two weeks. At the same time, the Bank of Israel joined the central banks of Turkey, Brazil and Russia in easing monetary policy, while China has already eased fiscally. Are forward-looking markets predicting a turn for the worse in the last bastion of the global recovery – EM growth? And is the monetary response likely to become more widespread? In our view, EM growth will still handsomely outperform DM growth over the business cycle, but it will not be immune to the downside in DM growth that appears to become more entrenched with each day that passes without a convincing policy response.

With DM policy gridlocked and growth moving dangerously close to recession as our base case, the only way to square the circle from a global perspective is either to expect EM growth to weaken meaningfully, or for EM policy to ease either aggressively or then at least pre-emptively (see Emerging Issues: Structural Alpha, Cyclical Beta, August 15, 2011). We have argued that more EM central banks are likely to respond to global growth risks by easing policy before 2011 ends. Some may worry right now about easing policy and exacerbating currency weakness, but delaying easing could put EM growth at risk and would require much more aggressive easing down the road.

Currency weakness: Symptom, not cause: Currency weakness is not something that needs to be addressed by policy-makers as an objective in itself. Rather, the recent weakness simply reflects a rise in the EM risk premium as investors take EM risk off the table due to: (i) a rising risk of economic and financial contagion from the DM world to EM economies; (ii) the reluctance or inability of DM policy-makers to respond convincingly to debt and growth concerns; and (iii) the reluctance of EM policy-makers to respond aggressively or pre-emptively to the risks to EM growth. While EM policy-makers can do very little about the first two concerns, they appear to have become more willing to address the third.

In doing so, they also address the risk premium that caused the sharp currency sell-off. Further currency weakness in line with monetary easing would then likely be orderly, not an indication of panic or de-risking. A reversal in currency weakness could come from aggressive monetary easing by DM economies (implying DM currency weakness and hence EM appreciation) or from an improvement in the prospects for EM growth and valuations. At the moment, there is very little appetite to use policy options aggressively to insulate growth, in which case it becomes exigent that easing be provided pre-emptively. A small but important set of EM economies are doing just that.

Easing is easier for some: Monetary easing in EM is not an open-and-shut case because global risks have to be balanced off against domestic issues. The global slowdown has complicated matters for many EM economies for at least three reasons. First, having just finished monetary tightening as part of a nine-month battle with inflation, the textbook prescription would be to keep monetary policy at its new, tighter stance and crush inflation expectations, sacrificing growth if need be. Inflation continues to be the primary concern for many EM economies including China, India, Brazil and Poland (among others), and an early reversal of policy tightening could push inflation higher. Second, the currency sell-off will likely worry many about their ability to cut policy rates (since this could exacerbate currency weakness), but is particularly a problem for the likes of Hungary (given its foreign currency loans – see FX Mortgage Plan Raises Deleveraging Risks, September 26, 2011) and Poland (given the impact of a weaker currency on debt, which is not far from the 55% ceiling that government is keen to avoid breaching – see “Poland: Election Preview – Poles to the Polls”, CEEMEA Macro Monitor, September 23, 2011). Finally, some LatAm central banks continue to face robust growth and would likely have kept raising rates had it not been for the emergence of global growth risks.

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