The Wall Street Journal-20080117-Emerging Markets Feel Drag of U-S-
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Emerging Markets Feel Drag of U.S.
To escape woes in the U.S., investors have piled into shares in fast-growing economies like China, India and Brazil. Now it looks like these markets might not offer a hoped-for refuge.
As the U.S. outlook has darkened in recent months, investors have started to question whether emerging markets can "decouple" from the U.S. economic train, and continue to grow as expected even as the U.S. slows. What's more, even if these economies prove resilient, the same may not be true of their stock markets, which instead of becoming less linked to the U.S., are actually becoming more connected.
Worries about the rising odds of a U.S. recession have been rippling across the globe and yesterday sent shares in Asia sharply lower, adding to recent losses.
Since the start of the year, benchmark indexes in Korea, Thailand, Turkey and Brazil all have fallen by 8% or more, and the Morgan Stanley Capital International Emerging Markets Index is down 7.9% in dollar terms.
That's a reversal from last year's stellar performance and bad news for investors who viewed these markets as havens from the credit and housing woes plaguing the U.S. and Europe.
While the developing economies remain healthy, their links with developed markets have grown since the last time the U.S. experienced a recession. In Asia, exports hit 55% of total economic output in 2005, according to the Asian Development Bank, compared with 45% of output in 2002. While intra-Asian trade has grown, about 60% of Asian exports are eventually consumed in the U.S., Europe and Japan.
So as the prospect of a U.S. recession grows, economists and investors are taking a second look at the idea that these economies can make a go of it on their own. Gray Newman, Morgan Stanley's top Latin American economist, last month issued a report saying growth in the region could fall short of the firm's own predictions.
"I am concerned that the full brunt of [a U.S. recession] has been underestimated by my colleagues throughout the emerging economies and in our commodities team," Mr. Newman said.
Morgan Stanley is predicting a mild U.S. recession and projecting a more pessimistic scenario for Europe and Japan than before, but "decoupling appears to be the watchword" among its experts when it comes to emerging economies, Mr. Newman noted in his report.
Others agree that the conventional wisdom about decoupling is off the mark. "There is a myth being developed" that emerging economies, especially those in Asia, can disengage from the rest of the world," says Harry Krensky of Atlas Capital Management, an emerging-market hedge-fund firm. "I don't think the story is going to work."
Mr. Krensky says emerging-market shares will be vulnerable if the U.S. slowdown pushes American consumers to pare back spending. He points to Li & Fung, a Hong Kong trading company that gets about two- thirds of its sales from the U.S. and is trading at about 35 times the past year's earnings. In contrast, the shares of one of its largest clients, Kohl's Corp., trade at just 11 times earnings. "The market is in denial," Mr. Krensky says.
Li & Fung's share price is now about four times its five-year low. Kohl's stock, meanwhile, hit a five-year low last week. Mr. Krensky's firm is betting that shares of companies with exposure to exports and the global economic cycle, like Li & Fung, will fall.
Traders who were anticipating another year of gains in emerging markets now see stark risks to that view. After predicting 25% gains in Latin American stock markets for 2008, Citigroup this week put out a report saying the region instead could face losses of equal size if the U.S. enters a recession.
There's still plenty to like about these economies. Emerging markets in general are on far sounder financial footing than in the past and have vastly improved their ability to weather weakness in the U.S. economy.
Together they are sitting on an estimated $4.1 trillion in central bank reserves, making a repeat of past crises highly unlikely. Local consumers are playing a bigger role in spurring economic growth, which helps to counterbalance the dependence on exports.
Economic impact aside, emerging-economy stock markets have become more highly correlated to those in the developed world in recent years. That's because global investors have piled into these countries, deepening the connection to world-wide investment shifts. And when markets get more volatile, they all tend to move together, as they have this week.
Even if a sharp U.S. slowdown has a modest impact on economic growth in emerging markets, "the effect on financial markets could be larger," says Ronald Frashure, co-chief investment officer of Acadian Asset Management, which manages $80 billion. The consequences might be more severe in markets that "had sparkling results in 2007, and which, as a result, had gotten quite expensive," he said, such as India and China.
