After a horrendous start to 2008, most emerging market investors are now extremely worried about the prospects for this calendar year. Forced out of their complacency by massive fund withdrawals from the asset class (dedicated EM funds had over $15 billion in redemptions in January, after $54 billion in inflows in 2007) and serious price damage, most investors are wondering what happened.
Prior to January the script was very clear; irrespective of what happens in the US, the emerging markets were economically decoupled and thus would be able to grow through a US slowdown. Reams of research were written on how China was a more powerful driving force for the EM countries than the US, and how intra-EM trade was growing much faster than EM exports to the G-7.
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Economists also pointed out the strong domestic growth dynamic in many of the larger EM countries and the huge infrastructure and capex cycle currently under way in India, China and other EM stalwarts. With continued strong consumer and corporate confidence, the dent in the EM growth rates should not be more than 1-1.5 percentage points of GDP -- this was the conventional wisdom.
For a time the markets acted in concert with this view. Post the initial crack in markets in August 2007, we saw huge inflows into dedicated EM funds and the asset class led by the BRIC countries held up much better than the equity markets of the G-7.
Even when Wall Street faded and hit new lows in December, emerging markets continued to defy gravity and traded significantly above the August lows. Investors seemed to buy into the economic decoupling argument, and were prepared to chase growth in markets like India and China.
However, come January and all this seems to have changed. The emerging markets are now leading global equity markets on the downside, and the maximum price impact has actually happened in India and China plays. The EM asset class is behaving more in line with historical patterns of being a levered bet on global growth. Investors seem to have forgotten about decoupling, in favour of the old adage of if the US sneezes, the world catches a cold type of a scenario.
What accounts for this change of behaviour? Why are investors suddenly not willing to buy into the decoupling thesis?
There are some explanations I can think of.
- Only now has the true magnitude of the economic mess in the US sunk in. Investors are now convinced this will be a deep and prolonged recession that will take the whole world down with it. Investors were willing to play along with the decoupling thesis, till such time as they felt that we would only get a slowdown or mild recession in the US. In a full-blown consumer-led G-7 recession, all bets are off.
- We are going through a classic de-leveraging and risk reduction episode, wherein many funds, deeply under water elsewhere, are booking whatever profits they have left in the EM space. Also many funds were playing momentum and hiding in the EM markets; with the markets melting down, nobody wants to be caught holding paper they weren't supposed to be involved with.
- The valuation gap between India/China and the US became too large to stomach. I have heard many global investors question why they should pay 20-25 times March 2009 earnings for an Indian company, when they can buy world class US MNCs with 50 per cent plus global exposure and with proprietary brands or technology at 13-15 times earnings. Investors accept the higher growth thesis, but are not willing to pay for it beyond a point.
- The relative price action between G-7 equity markets and the EMs also created an issue as by the beginning of January the US markets had pretty much fully priced in a recession (having fallen nearly 20 per cent from the top) while the EM price drop was far less than typical. The risk/reward thus favoured selling the EMs as opposed to the US, which had already declined by as much as one would expect in a recession. Investors felt they were getting paid to bet on an economic recoupling.
Be that as it may, the question becomes as to what to do now. I still believe that the decoupling thesis has merit, and that the economic performance of countries like India will sustain. We will see some drop-off in growth from 9 per cent plus to 7.5-8 per cent, but unlikely it will go lower. Corporate earnings should also be able to sustain a 20 per cent type of trajectory.
Most of the froth has been knocked off the Indian markets, and capital raising, which was rampant, has ground to a halt (witness the collapse of the Emaar-MGF IPO). The whole concept of SOTP will also be used much more judiciously. Speculation and outstanding positions have been dramatically reduced, and the retail investor is once again almost totally absent in direct form.
Valuations have come down to more normal levels with the markets now trading at 15-16 times the March 2009 earnings. Again not cheap, but if we can grow earnings at near 20 per cent, when corporate earnings are declining in most other parts of the world, it does not seem outlandish. The domestic investor base is strengthening with the insurance industry alone expected to pump in almost $20 billion into the equity markets this year. The market fall has not had much of an impact on this flow as of now. Mutual funds and PMS schemes also continue to get inflows.
I don't think this is the end of the bull market, it is a much-needed correction that will bring capital market intermediaries back down to earth. This dull and listless phase, with the markets being range-bound, may last a while but will set us up for a much more sustainable rally and will extend the bull run.
Most investors recognise that India is a high-quality long-term growth story, and that has not changed. The visibility and sustainability of our economic growth are among the best in the EM universe. The capital efficiency and quality of entrepreneurship are well recognised. Our problem was valuation and excess hype and froth, both of which are now getting corrected. This fall will clean out most of the momentum players and bring in many longer-term investors sitting on the sidelines.
Keep the faith as the game is not over yet, we will see new highs, though it may take some time.
