Column : Whats next for emerging markets

Written by Deepak Gopinath | Updated: Aug 8 2011, 07:34am hrs
After last weeks dramatic rout in global markets, investors are now facing a new, and disquieting environment in which long-held verities have been stood on their head. The so-called developed countries are acting anything but and the previously unthinkable has become commonplace. The US teetered on the brink of default in late July as its dysfunctional political process failed to find a way of putting its debt burden on a sustainable basis. And that has now prompted Standard & Poors downgrade the USs once bulletproof AAA credit rating. Investors are realising that what was once considered safe is actually rather risky.

Meanwhile Europes sovereign debt crisis is spreading and the International Monetary Fund worries that it lacks the funds needed to help bail out Spain or Italy. All this as growth in the US and Europe is slowing. Clearly, were not in Kansas any more.

So is it time for investors to thrown in the towel and embrace the new world disorder Not quite. Capitulation would imply a wholesale rush out of risk assets, including emerging markets and commodities, and into traditional safe havens, such as gold and, yes, US Treasuries (even now there really is no alternative to these for investors looking for a refuge in times of market uncertainty). While that will no doubt be the initial reactionmarkets do tend to be correlated during a panicinvestors will become more discriminating once the dust settles.

The reality is that the global markets are still awash in liquidity and will soon be drowning in it. The US Federal Reserve may have ended QE2, its $600-billion bond-buying programme, in June, but it is not about to withdraw that liquidity. Just the opposite. Now that fiscal stimulus is off the table, monetary authorities in developed countries will rely increasingly desperately on flooding markets with additional liquidity to try and prevent the dreaded double-dip recession. All that liquidity has to go somewhere.

Thursdays global market rout will accelerate the reallocation of capital from stagnant and dysfunctional developed economies and into well-managed emerging markets. That process is already under way, with investors moving assets into emerging market sovereign debt. Over the last month, yields on emerging market sovereign bonds have fallen sharply by up to 75 basis points as investors seek new safe havens now that the traditional refuges are looking decidedly risky. The prices of debt from countries including Brazil, Russia and Mexico, which are perceived as good risks, soared in July.

The next asset class to benefit from investors search both for yield and new safe havens is likely to be emerging market equities (EMEs). For the time being, risk aversion means that EMEs are not on the majority of investors radar, especially given concerns about the impact of the economic slowdown in the US and Europe on emerging markets. But this risk is over-rated in our view. Emerging economies will have to show that they are able to sustain relatively fast growth and control inflation even as developed markets slow in order for investors to consider reallocating assets into EMEs.

In consequence, the reallocation of capital from developed markets to EMEs will take time to develop, but will be inevitable because of the ever-increasing amount of liquidity being pumped into global markets by US and European monetary authorities searches for a home as disorder in the developed world continues to run rampant. Liquidity creation will fuel inflation and emerging market currency overvaluation, and will also boost commodity prices as investors seek higher returns by investing in natural resources.

Of course, not all emerging markets will benefit equally from the asset re-allocation out of developed markets. As mentioned above, those countries that have demonstrated an ability to control inflation and sustain growth in the face of a slowing US and Europe are best positioned to benefit.

Looking across the major emerging markets, we remain bullish on countries like Russia and Indonesia. In Russia, inflation is falling rapidly, supporting the equity market, while Indonesian equities have been largely unaffected by global contagion, though the equity markets recent strong gains limit further upside. China, too, is relatively well positioned, even though the inflation cycle may take longer peak than earlier anticipated because of slowing global growth.

At the other end of the spectrum, the outlook for Brazil and Turkey remains negative. Brazil continues to lack a coherent economic strategy to deal with inflation. And, in Turkey, continued political turmoil will weigh on equity markets until later this year; markets are only likely to turnaround if the economy achieves a soft landing towards year end.

India lies somewhere in the middle. It has been hit hard by the global equity market correction. The country is not, at the moment, an obvious choice for investors looking to re-allocate assets away from developed countries, given slow progress on reforms combined with the ongoing struggle to control inflation. The solution to Indias inflation problems will require structural reforms that will be long in coming. However, the governments progress in pursuing its legislative agenda would be positive for markets. The bottom line is that ongoing crisis in the developed world could be an opportunity in disguise for emerging markets, but only if they play their cards right.

The author is global markets director of the research service, Trusted Sourceswww.trustedsources.co.uk