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BusinessWeek.com
May 22, 2006
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Behind Emerging Markets' Malaise

"It's not a complete meltdown", says S&P's Alka Banerjee, who sees the slump as a natural reaction to the sector's rapid advance

After a long climb, emerging-market stocks have taken a startling tumble. On May 22, the Morgan Stanley Capital International Emerging Markets index fell for a 10th straight day, its longest skid since August, 1998. In India, the Bombay Stock Exchange Sensitive Index finished down 4.2%, recovering from an early 10% plunge that shut down trading for an hour.

The preceding run-up in prices helped set the stage for emerging markets' sudden slump, says Alka Banerjee, who focuses on international markets as vice-president of global index management at Standard & Poor's. "There had to be a pullback," she says. "It doesn't mean in the long run these [equities] are bad bets."

Only recently emerging-market stocks were at all-time highs. The S&P/IFCI Composite index, which tracks emerging markets, surged 20.6% in the first four months of the year. This month, the index has shed 6.3% through May 19. The S&P/IFCI Turkey index alone tumbled 18.9%.

Banerjee recently spoke with BusinessWeek Online reporter Marc Hogan about the factors weighing on emerging-market stocks and what they mean for the rest of the world. Edited excerpts from their conversation follow:

What's behind the volatility we're seeing in emerging markets?
The genesis is in most of the activity that the markets around the world have seen in the last few weeks. You have rising interest rates, expectations of inflation, and high commodity prices. Commodity prices have taken a beating in the last few weeks, but it's also the momentum that has been building up.

Emerging markets have had a good three-year run. They've been up and up and up. This year, all of a sudden, in the last four months they're up 20.6% [through Apr. 30], though individually the rates of increase have been different. That's a very high rate of increase, and at some point profit-taking had to occur. People have pumped huge amounts of funds into emerging markets in the last year [or more]. At some point investors were bound to get edgy because a lot of this money is coming from hedge funds. That kind of money does seem to move out very quickly, and it seems that that ride is over.

But emerging markets are not yet negative even for the year. They've lost some of their value, but they're still up a lot. There's more volatility because people don't know where things are. They don't know if they're overvalued. They don't know whether they should pull out, or if there's still some [upside] left. And it's not just specifically emerging markets. All these fears are pretty universal. This has been in the U.S. markets, too. Emerging markets, because they've had such a run-up, have obviously fallen a lot more than the others.

Along those lines, what implications do the emerging markets' recent declines hold for larger markets globally?
There are two schools of thought. One school says we should just go overseas and let U.S. [asset] allocations remain where they were. Another school of thought says there's value in the U.S., and you should be here. I don't think there's a clear consensus on where market value lies at this point. There's too much volatility.

It's amazing the amount that commodity prices have gone up. Interest rates have gone up, and bond prices have crashed because of that. Some people are just saying put [your assets] in cash and Treasury bills, because that's the safest place to be. My personal view is that these markets have gone up so much they had to pull back. It's natural.

How do higher U.S. interest rates affect emerging markets?
If you have higher interest rates in the U.S., people can invest in U.S. government securities and get reasonable enough returns without having to take on the additional risk and volatility associated with an emerging market. You lend here and you're fine, you get good enough returns, especially because these emerging markets have gone up so much that maybe it's time to pull out.

It's the same thing in Japan, where interest rates have gone up. You even saw a currency crash a few months ago in Iceland. People pulled their money out of Iceland because interest rates came down there, and these developed-market interest rates went up. The differential was much less.

What should investors be looking for in these markets? Are there any areas of opportunities after the recent weakness?
In earlier times, when emerging markets used to have these booms and crashes, a lot of the crashes came because there were inherent inefficiencies in these markets. This time I don't see that so much. There is a lot of run-up because of commodities. Emerging markets are being propped up because of commodity prices going up. It's not just because of pure speculative buying.

Meanwhile, countries like China have gone up because their fundamentals are very strong. There are different reasons, all of which are valid reasons for countries to go up. Even if the markets have pulled back, those fundamentals still remain. They haven't changed.These markets still are a good bet. How much allocation do you give to it? That's an individual manager's choice. I don't think you'll see a crash like in the 1997 Russian crisis, where there were inherent inefficiencies that were revealed.

What factors could exacerbate the recent weakness? Are there any other potential trouble spots?
[The key factors remain] commodity prices, interest rates, and fears of inflation. But the fundamentals that drove these markets up still look good -- unless oil crashes, which I don't really see happening. Or if India, China, and Taiwan suddenly lose all their growth patterns, which again is hard to imagine in the next few months. I don't imagine anything going drastically wrong unless what we've been seeing suddenly reverses.

In general, again, emerging markets have not given back all their gains for the year. It's not a complete meltdown. It's just a natural stop to the heady gains that we've seen.