The Emerging Market Boom Is Over

07/29/2008 12:00 am EST

Focus: MARKETS

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alexander Young, international equity strategist for Standard & Poor’s, says a weaker economy and the credit crisis have ended emerging markets’ big boom.

While emerging market (EM) economic momentum continues, decelerating growth in the US, Europe, the UK, Canada, Japan, and other developed economies is giving rise to concerns that slowing export demand will pressure profit growth for emerging market multinationals.

In addition, the problems in the credit markets have made investors around the world more risk-averse and caused them to pare exposure to more volatile asset classes in general.

Strong demand and soaring commodity prices are fueling a major increase in EM inflation rates, according to Global Insight, an independent forecasting firm, overall EM CPI rose to 9.7% in May from only 5.1% a year ago.

With EM per-capita incomes averaging only about $3,000 a year, food and energy expenditures comprise a much larger portion of consumer spending than in developed countries. We think this magnifies the impact of record commodity prices on overall inflation trends.

As a result, all four BRIC central banks (Brazil, Russia, India, China) are now raising bank reserve requirements and short-term interest rates to mitigate pricing pressure. In our view, this could put upward pressure on EM currencies and not only undermine the countries’ ability to compete around the world but also lead to slowing economic and earnings growth.

As such, we don’t expect another year of strong EM equity outperformance. We lowered our year-end MSCI EM index target to 1175, which equates to a calendar year decline of 5.2%, [from] our prior target of 1275, which implied a 2.4% gain for 2008.

We believe [Asia’s] domestic economic outlook remains strong thanks to rising per-capita incomes, increasing consumption, and significant infrastructure investment. But after several years of solid outperformance, equities in emerging Asia have lagged those in most other international markets this year, and we expect the trend to persist through 2008.

Latin American equities are the best-performing major equity asset class this year, and Brazil’s performance has been especially strong, allowing it to surpass China and India to become the world’s largest emerging equity market.

S&P Equity Research believes Latin America’s strong performance has been driven by a relatively benign macroeconomic environment, increasing consumption, strong earnings growth momentum, and low relative valuations.

Global Insight estimates Latin American real GDP growth of 4.6% in 2008, with Brazil, the region’s largest economy, forecast to post growth of 5.1%. Additionally, Mexico is weathering the US slowdown relatively well and is expected to post 2.9% real GDP growth in 2008.

However, from a longer-term perspective, recent selling has improved the risk/reward ratio of the EM equities. The asset class recently traded at a 2008 estimated P/E-to-growth (PEG) ratio of 0.77%, reflecting consensus expectations for a 15% increase in 2008 earnings and a 2008 estimated P/E of 11.5x.

We believe long-term oriented investors should maintain exposure to this asset class, as we think the infrastructure and consumption-driven secular growth of developing economies remains intact.

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