China and Brazil's stocks are down nearly 30% from the 2010 highs–but unlike the U.S. and Europe these countries have room to cut interest rates

09/23/2011 11:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Stunned because emerging stocks markets in countries such as Brazil and China are down by 25% or more and still falling? Relax. We’ve got these stock markets right where we want them.

As of the close on yesterday, September 22, both Hong Kong’s Hang Seng index and Brazil Bovespa index were down 28% from their respective November 5 and November 4, 2010 highs.

And they don’t show any appreciable signs of slowing their plunge. On September 22 the Bovespa fell 4.82% and the Hang Seng was down 4.85%.

The reasons? Fear that has produced a flight to dollars from just about everything else. On the day the dollar was up 1.1% against the Brazilian real, for example, and that drop was as small as it was only because the Banco Central do Brasil intervened to prop up the real. Before that intervention the real was down 4.1% against the U.S. dollar. As of the close on September 22 the real was down 9.4% against the U.S. dollar since September 14.

A major part of that fear is worry that the slowdown in the economies of the developed world is slopping over to depress growth in emerging market economies. Yesterday, for example, the rout in Chinese stocks took off after the purchasing managers’ index came in with a reading of 49.4, down from 49.9 in August. This marked the third straight month with the index on the wrong side of the 50 level that separates economic growth from economic con traction.

And if China’s economy (and by inference the economies of other developing countries) is slowing, then demand for commodities such as copper and oil must be falling.  On the futures market copper fell 8.7% on September 22 and oil (West Texas Intermediate) dropped 6.5%.

Of course, that drop in commodity prices fed back into further drops in the price of commodity producers, whose shares dominate the markets of countries such as Brazil and Australia. So, for example, the iShares MSCI Australia Index ETF (exchange traded fund) dropped 5.5% on September 22.

But speaking of feedback, notice how this drop in commodity prices, which is helping to kill emerging market stocks now, also at some point leads to a reversal in these markets, raising share prices, and a pick up in economic growth. Most developing economies have been locked into a battle with rising inflation that has seen central banks raise interest rates again and again, and impose other measures such as China’s series of hikes to bank reserve requirements in an effort to slow their economies and thus damp inflation. But with commodity prices coming down, these central banks can anticipate a slowing of inflationary pressures that, once they have a couple of months of evidence, will lead to interest rate cuts.

Because interest rates are so high in these developing economies—6.56% in China and 12% in Brazil (even after a cut of one-half a percentage point in September)—central banks in these countries have lots of room to cut interest rates to stimulate their economies once falling commodities prices show that inflation is moderating.

Developed economies, on the other hand, don’t have that positive feedback loop. The benchmark interest rate in the United States is already effectively 0%. Hard to see how the Federal Reserve can go any lower.

I don’t know how much further emerging market stocks or commodities prices may fall—but the decline is self-limiting. At some point central banks in these countries will start cutting interest rates in order to stimulate growth and that will draw a line under falling stock prices in these markets. Not yet, I’d guess. Not as long as fear overwhelms every other approach to the financial markets.

But that feedback loop is real and it will support stock prices in these emerging markets eventually.

 

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