Herd starts to turn from emerging markets

LONDON (Reuters):  If emerging countries have been the only fully functional engine of the world economy since the credit crisis, then the rising chorus of concern about the outlook for financial markets there must arouse alarm.

Anxiety about the U.S. slowdown and pumped-up world inflation has prompted many to quietly cross fingers that these economies — which generated almost three quarters of world growth over the past two years — will again save the day.

But with China in the vanguard of the emerging world and now the world’s second largest economy, it’s not hard to see why fears of inflation and the policy agility to control it, as well as nagging doubts about data transparency, are a worry for all.

This week’s news of a rise in Chinese consumer inflation in May to a 34-month peak of 5.5 percent and further tightening of bank reserve ratios in response did little to soothe the nerves.

Shanghai’s speculative B share index, the hard-currency section of the local market used by overseas players, has now lost some 28 percent in past six weeks as overseas confidence ebbs.

For many, the turn on China is just a bellwether for the rest of emerging markets. So far this year, MSCI’s emerging index has underperformed its global counterpart by just 2 percent. There are some who think that’s just for starters as global liquidity tightens.

Even a year ago, identifying a committed emerging market bear would have been tricky. Suddenly, they are everywhere.

Deutsche Bank’s top emerging equities strategist John-Paul Smith, who sees emerging market equities underperforming developed markets by some 15 percent by year end, told Reuters last week he sees a “significant chance” of a major selloff.

U.S. market strategist Richard Bernstein talked of “monstrous” risks to emerging markets this year. And JPMorgan’s emerging market research chief Joyce Chang warned of steeper interest rate rises to come in the emerging world this year.

On top of monetary tightening fears, Nomura and Natixis analysts both flag worries about electricity shortages in Chinese cities as price controls deter companies from expanding capacity while more use of generators shoves up diesel costs.

“Investors appear to have underestimated the impact of electricity shortages and credit tightening in China,” Nomura told clients. “While equity markets have recently corrected, investors do not appear to have re-adjusted their expectations.”

That tallies with Bank of America-Merrill Lynch’s June fund managers’ survey, which showed asset managers still marginally favour emerging markets over the United States even though they’ve more than halved overweight positions since late 2010.

Herd Turns

So is there a major shakeout coming?

With the exception of the credit shock and synchronised global recession of late 2008 and early 2009, emerging markets — and, at least partly by extension, commodity prices — have been the investments of the past decade.

The reasoning is fairly clear — a dramatic expansion of the world economy to absorb billions of new workers and consumers from China to India to Brazil and an intensive growth and demographic story that would endure for decades.

While few doubt that is what has happened or even question projections for their rising share of global output by 2050, the concern is that there is many a slip between cup and lip.

At least that’s the worry for portfolio investors, some of whom have been here before. The long-term growth and demographic arguments were also popular prior to the spectacular global emerging markets bust of the late 1990s.

For sure, there are a host of structural differences between that episode and now. For a start, China and India are far more significant players, most emerging economies are surplus countries with giant hard cash reserves, and financial, trade and supply chain globalisation is far advanced.

But a much-debated survey last year from Credit Suisse and London Business School showed that despite higher growth between 1975 and 2009, emerging equities underperformed developed peers. Questioning links between the two, it said long-term assumptions were often excessively discounted in prices too quickly.

If this turned out to have happened again, as in 1997/98, the flight back to western markets could be massive. The final throes of the dot.com bubble, where Silicon Valley was seen as a growth market free of currency and political risk for burnt U.S. investors, were partly blamed on the Asia markets bust then.

The question for some investors is whether Treasury bonds will be the returning bubble this time around.