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The economic ripples that began with a slowdown in China have become crashing waves on unexpected shores. The attending drop in commodity prices has added to the self-inflicted political challenges of Brazilian president Dilma Rousseff, threatening to bring down her government. In recent weeks Saudi Arabia has been pulling billions of dollars from Western asset managers to plug the hole in its budget. And while low oil prices may yet be a boon for American and European consumers, for now the greater concern is that China is exporting deflation as well as iPhones. This poses a renewed challenge to central bankers' inflation targets, pushing back the timetable for when the Fed will eventually get off zero.
Unsurprisingly, these intertwined economic stories have meant poor returns lately for emerging markets stocks. In August the MSCI Emerging Markets index slipped into bear market territory in US dollar terms. Taken as a whole, emerging markets stocks trade at reasonably attractive valuations relative to their developed markets counterparts. Unfortunately, now is not the time to pile in - things could get worse before they get better.
More than half of the emerging markets index's recent drop is due to currency movement, resulting from US dollar appreciation, not movement of the underlying stock prices. With the prominent exception of Brazil, most emerging stock markets have suffered far more modest losses – and in some cases have registered gains. That suggests that investors in emerging stock markets are not all that pessimistic - yet.
In August my colleague Jared Nishida wrote about the evidence that US stocks are showing symptoms of being in the late stages of a bull market (see Tired Bull ). As recent market activity has borne out his thesis, it becomes increasingly difficult to foresee an environment where US stocks do poorly but emerging markets stocks perform well.
This is because to a great extent emerging stock markets rely on the optimism of foreign investors – and a change in investor mood can cause sharp, disruptive outflows. As US stock markets begin to creak, we anticipate that many investors are likely to move assets held abroad home. The more attractive valuations in emerging markets are no defense against the increasing risk of capital flight.
An opportunity may yet develop in emerging markets stocks – but it's probably not here yet. For now the distress among natural resource equities – a market sector that shares many common economic factors with emerging markets – offers more compelling value with a greater margin of safety.
The above article represents the opinions of the author as of 9.30.15 and is subject to change at any time due to market or economic conditions or other factors.Print