Fears are growing that the exuberant bull-run for emerging market equities will come to an end this year with investors rejecting sky-high stock premiums and profitability forecasts, amid growing anxiety that emerging markets will not be spared the impact of a US recession.
“It now seems to be the end of the cycle for over-enthused valuations for EM stocks with current premiums clearly not justified by the fundamentals,” Guilherme Paiva, equity strategist at Deutsche Bank told Emerging Markets.
As benchmark indices tumbled and bounced back this week in tandem with developed bourses - discrediting preachers of the EM decoupling myth - market participants are starting to predict a dumping of emerging stocks.
“Given the volatility of the last week I wouldn’t be surprised if we see significant capital flight by cross-over investors in the next couple of months,” added Paiva.
Asian stock markets on Friday ended a volatile week on a more promising note, buoyed by an agreement on a US fiscal stimulus package. Hong Kong’s Hang Seng index closed 6.7% up while India’s Sensex Index gained 5.73%, though still 15% off its all-time high earlier this month.
This followed Tuesday’s crash which sent Shanghai’s stock market plunging 7%, adding to Monday’s 5% fall, while trading was suspended in Bombay as the Sensex index tumbled almost 10%.
But the wild swings in EM bourses this week are alerting investors to the notion that these bourses may be losing their diversification value after a 5-year investment binge that has – contrary to popular belief - increased the correlation of global investment strategies, according to a Citigroup study.
The research shows that, across stock markets of 43 countries, general market shocks explain about 65% of the daily variance in share prices across all markets since 1997. However, in the year-to October 2007, 85% of the daily volatility of all stock markets was correlated.
“Some of the emerging markets that were least correlated with the United States in 1998 are now correlated, particularly Mexico, Argentina, the Philippines, and India. Other work by the IMF shows that this tends to rise in downturns, further exposing emerging stock markets to contagion from the United States,” said Don Hanna, head of emerging markets research at Citigroup.
As a result, this week’s volatility could herald the end of the ‘irrational exuberance’ for EM stocks, investors suggest.
“Financial players have looked at stocks that are in fact cyclical – textiles, car parts, shipping companies - and unjustifiably priced in unit growth and increased profitability as well US decoupling - that’s the only way you can understand the 30 times P/E multiples,” Harry Krensky, founder of Atlas Discovery Capital, an emerging markets hedge fund in New York, told Emerging Markets.
“But this overexcitement in valuations, driven by the fundamental economic change that is taking place particularly in Asia, has happened too quickly,” he added. “Given the volatility of the last week - this will have to change.”
Pava argues that the outperformance of EM equities has effectively erased the valuation gap between EM and developed market stocks over the past 5 years. “EM stocks should not trade at a premium to developed markets because they have a higher costs of capital,” he said.
He also pointed out that equity stakes in export-orientated industries in mature markets were more competitive since many European companies and US are already stepping up their exposure to higher growth and profitability opportunities in emerging markets.
With tightening trade and financial linkages with the US, Asian stock markets - particularly Singapore, Malaysia, Taiwan and Korea - will be most exposed, along with Mexico and Brazil, Pava added.
A fundamental change in risk appetite was already under way for stocks in CEEMEA, according to one London-based syndicate head. “It seems investors want to reduce risk exposure at all cost. This means they are trying to sell off their equity positions across the board and try to invest in cash,” he said.
Nevertheless, developing economy fundamentals look positive, so “their growth characteristics will become even more desirable in a world where growth is becoming increasingly scarce,” Hanna said.
Africa is least vulnerable to a global re-pricing of risk and de-leveraging, according to Razia Khan, head of African research at Standard Chartered. She argued: “The small size and relative illiquidity of African markets have acted as a natural limit on the extent of offshore participation, serving to reinforce the degree of Africa's non-correlation with the rest of the world.
“Equity investors face the risk of moving the price against themselves, if they try to sell significant amounts of their holdings at any one time.”