The sell-off looks like an overdue correction rather than the sign of an impending crash. As investors rethink the risks, some remain bullish
Two weeks can be an eternity in emerging-markets time.
In the first week of May, stock markets in countries such as India and Brazil were hitting giddy new highs, following through on spectacular 2005 returns. New-paradigm bullishness about the outlook for developing-country indices abounded, based on the huge windfalls many of these nations are reaping from soaring commodity prices and the resulting improvement in their fiscal position.
Shift to the week leading up to May 22. Suddenly the expectation of higher U.S. interest rates and falling commodity prices is turning that paradigm on its head -- and the hottest emerging markets are in the throes of a 10-day sell-off.
On May 22, the Korean Kospi lost 2.5%. Hong Kong's Hang Seng Index shed more than 3%, while Jakarta's Composite Index gave back 6%. Meanwhile, in Latin America, Brazil's and Mexico's main equity indices shed 3% and 4%, respectively.
So violent was the decline at Indian Sensex (it fell as much as 10% on May 22, before closing down 4%) that the government was trying to calm margin-call panic and police were reportedly on the lookout for suicidal investors. Last week saw similar global bloodletting. All told, the MSCI Emerging Markets Index, which tracks 26 markets in Asia, Eastern Europe, Latin America, and the Middle East, has tumbled 16% from its May 8 high.
MONEY MOVING. So are we on the brink of a true emerging-markets crash, marked by debt defaults and currency devaluations? Probably not. For now, the emerging-market sell-off looks more like a long-avoided but inevitable flu than an outright pandemic (the likes of which broke out in Asia in 1997). "The term 'contagion' is premature here," says Andrew Karolyi, a professor at Ohio State University's Fisher College of Business who focuses on emerging-market investing.
Nonetheless, the pain of the pullback is undeniable. Investors have been plowing record amounts of money into emerging-market ETFs (exchange-traded funds) and mutual funds, the assets of which ballooned from $59 billion in 2004 to $103 billion last year. The momentum carried into 2006. Almost $3 billion poured into the asset class just in the week that ended May 10, bringing this year's emerging-market equity-funds inflow to $33 billion, according to Cambridge (Mass.)-based EmergingPortfolio.com Fund Research, a market-tracking outfit.
Through May 10, the stock markets of India and Brazil were up 35% and 41%, respectively, for 2006, in U.S. dollar terms. They have since fallen 18% and 21%. "Looking at the charts, it's clear that capital is coming out of more speculative markets," says Standard & Poor's market technician Christopher Burba.
HEALTHY LOSSES. It's a rude shock for the Johnny-come-lately investor, who had become accustomed to scoring double-digit gains on his emerging-market holdings. The India Fund (IFN
), a popular closed-end investment company, has seen its shares slide from their May 9 high of $65 to $46 -- a 29% plunge. The Dow Jones Industrial Average would have to shed 3,200 points to equal that percentage decline. The AMEX-listed Indonesia Fund (IF
) has fallen from a May high of $14 to $8.27 on May 22; the Dow would have to plunge 4,500 points to match that swoon.
The concurrent sell-off in commodities -- which had also been bid up to dizzying heights -- is further spooking investors. South Africa's mining stock-heavy FTSE/JSE Top 40 Index was up 26% in dollar terms through May 10, but has since given back nearly all those gains.
Some market watchers reason that the shakeout is not necessarily a bad thing. Mexico's Tequila crisis of 1994 and the Asian crisis of the late 1990s demonstrated that large waves of portfolio investment can be dangerous, since the tide can go out as quickly as it came in. "Maybe this is a healthy check on all the hot money," says Ohio State's Karolyi. "I suspect people who have been chasing the big returns will reassess their risk tolerance."
His research shows that emerging-market investors lopsidedly react to positive news, with large percentage gains in indices like India's Sensex amplifying the draw for fresh investment flows. That kind of frenzied buying pushed the index's estimated-earnings multiple up to 17 -- four points higher than the emerging-markets average, according to Bloomberg.
NO BULL RETREAT. Time for a reality check. Emerging markets "can't keep generating these types of returns," says Joanne Irvine, head of non-Asian emerging markets for London-based Aberdeen Asset Management. Irvine thinks investors are now trying to reassess the risk-reward profile of these markets against the backdrop of higher U.S. interest rates and commodity-price volatility.
However, she is quick to point out that the fundamental bull case for investing in emerging markets has not changed: "Our long view is that the economic environment for emerging markets has never been so good, with companies cleaning up their balance sheets and operating at a much lower rate of inflation than they have historically." Irvine is using the across-the-board sell-off to add to equity positions.
Some market watchers believe the markets have already experienced enough of a correction. S&P's Burba thinks that the MSCI Emerging Markets Index, which has tumbled 16% since its all-time high on May 8, is near an oversold position. Another 2% drop on that benchmark, he says, would test a critical support level. The bad news, though, is that emerging markets have a tendency to overshoot in either direction.
BusinessWeek Department Editor Farzad covers Wall Street and the markets from New York
