Column : US still holds key to equities markets

There is no doubt that recently emerging market returns have been spectacular. But this picture doesn?t tell the whole story. So, it is not quite right to think that emerging markets are going to save the day. They are not.

To see why, look at the facts. The MSCI?s Emerging Markets Index has delivered an overall US dollar denominated buy-and-hold return of 60% since January 1, 2008, in contrast to an average 26% return on the US and Euro zone indices. The Japan index lagged miserably with an annual return of 6.6%. Emerging equity fund inflows also surged to $80.3bn in 2009 ($60bn of which went to Bric), compared to $49.5bn of outflows in 2008 (EFPR Global).

Also, while emerging market indices showed the greatest gains in 2009, these markets also experienced the steepest fall from their five-year peak levels in 2007. The recovery in returns therefore has to be examined keeping the extent of the collapse in mind. From the most recent peak-to-trough (October 2007 to February 2009), emerging market indices fell by 98.5% with an even more astounding fall (127%) for the Bric economies. MSCI?s US index and the Euro index also experienced spectacular declines.

Changes in the indices from the trough to the end of 2009 suggest that while emerging markets recovered about 70% of their value, US and European indices recovered a not so shabby 55% of their value losses. Moreover, the emerging market and Bric indices stand at about 30% off their 2007 peak, as does the US index.

Many investors expect greater returns from emerging-market stocks in 2010. To examine the prospects for continuing returns, the key drivers of emerging-market growth deserve attention. Let us look at the biggest of these emerging markets, China.

Fuelled largely by aggressive government-controlled bank lending, the surge in construction, investment and consumer spending has raised worries of a hyper-inflated economy. Last week?s Chinese rate hike is seen as a broader move to tighten monetary policy to slow down an overheating economy. Chinese stock markets slumped after the announcement. If the trend towards higher rates continues, the prospects for continuing Chinese returns may wilt.

We must also remember that China?s economic fortunes ultimately depend on the US consumer. The US and the EU together are China?s largest export markets. Who will consume what the ?factory of the world? produces? It is unlikely that domestic demand in China alone will pick up the slack.

The US consumer has sharply cut back on demand for Chinese goods. Double-digit unemployment and eroded household wealth (the housing collapse, dwindling stock portfolios, and curtailed credit card access) imply that the revival in demand will depend on the recovery of the US economy.

Here there is very little to cheer about. The fact remains that the US economy is still losing jobs, albeit at a slower rate, and new job creation is feeble at best. An additional 85,000 jobs were lost in December and the unemployment rate remained at 10%, setting back hopes for a swift recovery. A point with which most economists would agree is that the US economy cannot recover without adding millions of new jobs.

In order to add new jobs the corporate sector requires unconstrained access to credit. It is disconcerting that the most current release from the Federal Reserve?s Assets and Liabilities of Commercial Banks in the United States indicates that ?loans on the books? in bank credit fell by half a trillion dollars between November 2008 and December 2009.

Interbank loans also fell by 67% during this period suggesting that banks are reluctant to lend even to each other. Securitisation markets where the ?shadow banking? system of loans that are securitised and passed on have also dried up. What is particularly worrisome is that the decline continued throughout December.

Tight credit does not bode well for hopes of a sustained recovery. With banks unwilling to lend, firms cannot invest in new capital or hire new workers. As households spend longer spells in unemployment, consumer spending will be curtailed, reducing demand further.

As demand falls, the vicious cycle continues. Minutes from the Federal Open Market Committee meeting in December suggest that the pickup in output and employment growth would be rather slow relative to past recoveries from deep recessions.

While emerging markets have shown remarkable resilience despite extreme fears, what will these markets have to do to manage their recoveries if the US does not bounce back quickly? The Internet revolution lifted the US economy from the recession in the early 1990s. Far-reaching corporate governance and regulatory reform helped Asia recover following the crisis in 1997. It is yet unclear what will help lift the US out of its current morass and that doesn?t bode well for the rest of the world.

?The author teaches international finance at the University of North Carolina, Chapel Hill