The decoupling theory is back in vogue. Emerging markets equity prices are at an all-time high compared with developed markets. The FTSE All-World All-Emerging index is up 66% since its lows at the end of October. The Shanghai Composite index has risen 45% this year in local-currency terms.
Money continues to flow into emerging markets funds. Since the beginning of the year emerging markets equities funds have seen net inflows of $22.3 billion, according to EPFR Global, a data provider, as investors gravitate again towards riskier assets in their search for yield. In contrast, developed markets funds have posted net outflows of $53.8 billion over the same period.
Asia is attracting the most money, with inflows of $7 billion this year, followed by Latin America. Funds specializing in EMEA equities have lost nearly $1 billion this year, although cash is beginning to flow back in on a weekly basis.
What lies behind the turnaround in investor sentiment towards emerging markets? One argument is that the outlook for many developing countries is now rosier than it was in January. Driven by China, where there are tentative signs of economic recovery, investors are now more confident about certain emerging markets and assets. An improvement in commodity prices is adding to some markets’ appeal. The Russian equity market is up 85% since January, for example.
Then there’s the view that emerging markets firms have strong earnings growth potential, with the prospects for companies in Asia and Latin America better than those in emerging Europe and the Middle East. Standard & Poor’s reckons that an emerging market equity valuation of 13.5x consensus estimated 2009 EPS represents fair value in the short term although there is the potential for an upward revision if global economic growth begins to pick up over the next 12 months.
Although the fundamentals in some key developing nations might be stronger than in the developed world, what’s really driving emerging markets’ asset prices is excess liquidity created by government stimulus packages. In other words the rally is leverage-fuelled.
In China, for example, one of the consequences of the government’s $585 billion two-year spending spree is that some corporates are using the funds to speculate on the stock market instead of for working capital requirements. One analyst said in March that as much as Rmb600 billion ($87.5 billion) might have been used for this purpose.
Every investor by now knows what happens to leverage-driven cycles. This rally might still have some legs to it but the bubble will burst sooner rather than later.
