He's Dubious About Decoupling

07/22/2009 10:24 am EST


Alexander Young

Equity Market Strategist, S&P Capital IQ

Alexander Young, equity market strategist for Standard & Poor's, says emerging markets won't separate themselves from the weak global economy, limiting their gains.

Since last year's 54.5% freefall, emerging market (EM) equities have dramatically outperformed so far in 2009. Through July 7th, the EM index rose 32.4%, which dwarfed the MSCI EAFE's 2.8% gain and a 2.5% decline for the Standard & Poor's 500 index.

While S&P's Equity Strategy believes EM equities will modestly outperform developed markets through year-end, we believe the pace will moderate significantly as volatility increases.

Given the exuberance currently surrounding this asset class, we think this is a good time to remind investors why they should temper their expectations.

In our view, the decoupling debate is too often framed in black and white. While EM economies and earnings per share (EPS) may be less dependent on the developed world than in past cycles, we believe the notion that they have completely "decoupled" from developed economies is an exaggeration.

EM equity correlation with developed markets is currently flirting with all-time highs. Through June 30th, the MSCI EM index sported a record 0.82 correlation with the S&P 500 and a near-record 0.93 correlation with the MSCI EAFE index. As such, EM equities have not been immune to the profit taking afflicting developed stock markets [recently].

In addition, uncertainty regarding OECD economic recoveries fueled an 8.7% decline through July 7th in the S&P GSCI Commodity index from its mid-June highs, by our analysis. This had a disproportionately negative impact on EM equities, as the energy and materials sectors comprise a combined 29.4% of the asset class's market capitalization, compared with exposure of only 15.3%, 19.4%, and 9.3% in the US, Europe, and Japan.

Another near-term challenge to EM equities is currency. A firm dollar detracts from US investors' dollar-denominated returns in foreign stocks, while a weaker greenback has the opposite impact. After a sharp rally for major EM currencies versus the US dollar since March, as risk aversion receded, increasing growth fears and commodity weakness recently began to weigh on currencies like the Russian ruble, the Indian rupee, the Mexican peso, and the Brazilian real, among others.

Lastly, at their recent peak on June 1st, EM equities were trading at 14.5x 2009 consensus estimated [earnings per share]. We believe the asset class was priced for a "V"-shaped global recovery and that lingering economic uncertainty will limit potential near-term P/E expansion.

In conclusion, despite our belief that healthier EM domestic momentum will fuel modest outperformance through year-end, we think EM equity volatility will increase. Our year-end MSCI EM target is 830, 10% above [recent] levels. While this exceeds the single-digit percentage advance we expect for developed markets, it represents a major deceleration from the blistering gains since early March.

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