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Contagion? No, Wake-Up Call


Pretty much everyone knows the Shanghai stock exchange is a casino. So after Chinese speculators propelled the bourse up by 135%, what's a measly 9% dip? To global markets, it apparently matters a great deal. Minutes after rumors of a government tax-policy shift triggered selling in Shanghai, investors began fleeing emerging markets from Mexico City to Mumbai. On Wall Street, already jittery over mixed economic news, China provided the spark for the steepest one-day dive in stock prices since March, 2003.

Is emerging market contagion back? Yes and no. Some sharp pullbacks are certainly way overdue. "We've had four straight years of record results for emerging markets," says Mark W. Headley, a portfolio manager at the Matthews Asian Funds. "Why on earth should we expect a fifth straight year?" It's been a smooth ride for these markets, and many forget that these are still immature bourses lacking a savvy local investor class to give them a firm foundation.

But don't expect a repeat of the kind of global meltdowns that swept Asia, Latin America, and Russia in the late 1990s. True, a number of markets are clearly overbought. Venezuela's market soared by 79% in the past 12 months, while those of Peru and Vietnam are up a scorching 158% and 182%, respectively. Foreign investors—who tend to cut and run at rough moments—are a major factor. In 2006, $70 billion poured into developing-nation stocks: In 2002, just before the latest boom, $2 billion was yanked out.

The similarities with the go-go '90s end there, though. In times past, developing nations were famous for their reckless public finances and balance of payment problems. "Now, most of these countries are pursuing prudent policies and even running budget surpluses," says Keith Savard, the Institute of International Finance's director of global economic analysis. The top 40 emerging markets last year ran current-account surpluses equal to 3.2% of gross domestic product, compared with 0.5% in 2002.

Yet even if we don't get Asian Crisis Part II, we could get The Year of Volatility, especially if investors keep pumping funds into markets like China's, where machinations by a handful of players can lead to wild swings. "The Shanghai market drop is a reminder that emerging-market stocks are a volatile asset class," says Donald Elefson, a portfolio manager of Excelsior Emerging Markets Fund.

Chinese stocks certainly seemed poised for a hit. China's export boom, loose-money policies, and huge inflows of foreign capital have produced an enormous liquidity bubble. Even after their 9% dive, says portfolio manager Romeo Dator of U.S. Global Investors Inc. (GROW), Shanghai A shares trade at 36 times earnings. As authorities struggle to talk the market back to earth, Chinese stocks will remain high-risk bets. "The fear is that they will take one step too far and take the whole market down."

DEFENSIVE INVESTING

With such jitters in the air, it's a good idea for investors to pull back. "This correction will take time to unfold," says Arthur Budaghyan, managing editor of BCA Research's emerging market newsletter. Stocks in China, the Philippines, and Argentina appear especially vulnerable, he says. Yet while stocks could drop around 10% off their recent highs before rebounding, that's far less severe than the 25% plunge most emerging markets experienced in the summer of 2006, after a spike in 10-year U.S. Treasury bonds sparked worries of rising global inflation.

Even the prospect of a 10% pullback, though, is prompting Headley to take defensive action. He is shunning many Indian and Chinese stocks, some of which he figures could still decline by 50%, and instead loading up on low price-earnings plays like Korean banks. "I've been there before," Headley says. "And when the music stops, it isn't pretty."

By Pete Engardio, with Christopher Power in New York


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