Skimming the froth

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Sep 14th 2008
From Economist.com

Emerging markets are no longer a safe haven


SO MUCH for emerging markets being the new safe havens. The MSCI emerging-markets index has lost a quarter of its value over the last three months (see chart) and emerging-market currencies have taken a battering over the last week or so.

The main reason seems to be risk aversion. Investors have been spooked by the bad news from Fannie, Freddie and Lehman and are reducing their exposure. American investors in particular seem to be reducing their overseas holdings; the dollar has risen dramatically since the start of August against both the euro and the pound. Traditionally, emerging markets have always suffered in such sell-offs.

But in the last couple of years, the pattern changed. Emerging-market fundamentals had improved a lot since the 1990s, with many countries enjoying current-account surpluses, and thus no longer dependent on “hot money” from international investors. Indeed, Asian central banks were key suppliers of finance to the American government. The developing countries were, it was argued, creating their own economic momentum that left them less in thrall to the vagaries of American and European growth. That was when they started to be talked about as the new safe havens.

So why have we reverted to type in the last few months? A good deal of the strength of some emerging markets (notably Brazil and Russia) was tied up with the strength of commodity prices. As they retreat, investors are exiting the more obvious commodity plays. (Indeed, they are also selling gold, somewhat undermining its status as a safe haven.)

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The good news is this sell-off means that emerging markets no longer look overvalued. According to Merrill Lynch, they trade on a trailing price-earnings ratio of 11.4, the lowest since September 2001. They no longer trade at a premium to developed markets.

Alas, this does not guarantee that the bottom is imminent. Emerging markets have been subject to some violent downswings in the past and, with the economic health of some countries deteriorating, there is scope for some nasty shocks in terms of corporate profits and bank losses. Long-term investors may be willing to put up with the bad news in the hope of a rebound in 2009 but it seems unlikely that we will be hearing any more safe haven talk for a while.

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In addition, a lot of emerging markets had higher inflation, and thus higher interest rates, than countries in the west. This made them subjects of the “carry trade”, where investors borrowed money in a low-yielding currency and invested the proceeds in a higher-yielding one.

In a world of deleveraging, the carry trade is the first thing to go, regardless of the merits of the country concerned. David Simmonds of the Royal Bank of Scotland says that “the safer currencies, like the Russian rouble or the Brazilian real, are vulnerable precisely because they’ve been perceived as fundamentally strongest and are the most heavily owned.”

Mr Simmonds adds that “central and east European markets are especially at risk, with richly-valued and still-appreciating real exchange-rates and high external-financing needs.” A further problem is that high inflation rates are now perceived as a weakness, with some countries in danger of overheating.

There have been significant outflows from equity markets as well. According to Michael Hartnett of Merrill Lynch, some $24 billion of emerging-market funds have been sold, around 5% of assets under management and a quarter of the entire inflow during the bull run of October 2002 to May 2008.