Emerging Markets Weekly

The notion of economic decoupling of emerging market economies from developed markets was widely dismissed in recent months given the significant economic downturn in the emerging markets and outright recession in some countries.

It is clear that the global economies are very closely connected through trade and capital flows even more so in recent years; however, the divergence in prosperity and economic growth in the emerging markets vis-à-vis the developed world is quite striking this year.

Two thousand and nine will see a sharp contraction in economic growth in OECD nations. The U.S., Europe and Japan are all experiencing recessions of significant magnitude. Japan is currently having its worst post-war economic recession.

In contrast, emerging markets are still growing on average. The IMF is forecasting roughly 3 percent expansion in emerging market economies with China and India leading the way. China may even see its economy grow 8% in a very challenging year.

China's stock market has risen roughly 30% since November in anticipation of this economic growth. Brazil's stock market has also appreciated for similar reasons, Chile's too. These results contrast greatly to the almost daily deterioration in Canadian, U.S., European and Japanese equities.

It seems clear that the emerging markets will actually lead the way out of this economic mess. The banking systems of China, India, and Brazil are in very strong relative positions and lending has exploded in China in January.

In what looks to be the toughest year for the global economy, emerging markets are offering a strong ray of hope for recovery.

Emerging Markets Weekly

After a tough year, emerging market investments have been relegated to also-ran status in the popular press, but this sentiment is at odds with the facts. Every broad developed market index (not individual country) is under water over the past decade according to MSCI Barra but not so for developed markets. The MSCI BRIC Index is actually up 9.01% on an annualized basis over the past decade and this includes the latest setback including a 45% fall over the past year. Investors who did not invest in the BRIC countries are getting a second opportunity to do so this time around. Unfortunately, many investors have been selling BRIC in favour of bonds and GICs.

The sharp rise in bond holdings over the past year is motivated by the strong performance of bonds as an asset class and flight to safety issues. More bond buying pushes yields lower and prices higher and creates its own momentum. With government bond yields exceptionally low, investors will make the same mistake by missing EM, but this time by investing in bonds rather than by owning developed market foreign equities.

History should not be followed blindly and just because MSCI BRIC bettered the MSCI World Index by roughly 11.5% per year on an annualized basis over the past decade does not mean that will happen again. Developed markets are now undervalued as are emerging markets. What are less compelling now are government bonds. The fall in bond yields over the past year suggests that bond could very well be the losing investment over the next decade. Now is the time to rebalance portfolios out of bonds and into emerging markets.

Emerging Markets Weekly

Anyone who doubts that the BRIC emerging markets are cheap needs only consult the standard yardstick for measuring equity market valuations, the P/E ratio. It is patently obvious that valuations in emerging markets reached very high levels at the peak of the past bull market in 2007. India and China were particularly overvalued as investors all wanted too much of a good thing. The notion that growth could sustain the very high P/E multiples was in hindsight overly optimistic, However, market are inefficient on both the upside and downside and these markets have clearly overshot to the downside.

Valuations are such that the BRIC nations individually and collectively are very cheap. Brazil, China and India are all trading near historical lows reached at the bottom of the Asian Currency/Russian Debt Crises in 1998 and Russia is the cheapest on record. The current economic slowdowns in these countries are an order of magnitude less severe this time around because the economic fundamentals in these markets are far better.

The long term fundamentals for investing in these countries, we believe, have not changed. Urbanization and industrialization are leading to higher rates of productivity growth, faster GDP growth and higher profitability at the corporate level.

The fact that these markets are as cheap or cheaper than the developed markets in the US and Canada is strong justification for investing in these countries, China, India and Brazil in particular are likely to lead the global economy out of recession because they are not hampered by weak banking sectors or high levels of indebtedness. Since valuations have declined to level not seen since 2002, investors are being given a second chance to buy into the emerging market growth story.

Emerging Markets Weekly

Stocks in Russia are now dirt cheap and oil and gas producers are priced more cheaply than anywhere else in the world.

Share prices of three of the biggest energy producers in Russia -- Gazprom, Rosneft and Lukoil -- are down by roughly three-quarters or more from their 52-week highs. These three companies figure most prominently in Excel Emerging Europe fund accounting for roughly 30% of fund assets.

Capital flight has put a serious damper on capital spending plans and reduces the outlook for production over the next few years. However, these companies look very cheap on a historical earnings basis.

State-controlled Gazprom is trading at two times 2008 earnings according to Thomson Reuters. Rosneft is trading at three times earnings and Lukoil is trading at just over two times earnings from last year. The market is dirt cheap and offers investors access to the world's largest gas reserves in the world not to mention a very large stream of global oil production.

Investors have sold out of Russia due to a one-way bet on ruble devaluation after the bank took the currency down stepwise in 20 mini-devaluations since last August. The currency is off by roughly 30% versus the U. S. dollar over the past six months but is stabilizing and may be forming a bottom here.

The decision by authorities to defend a slow depreciation of the ruble in the face of capital flight caused investors, even domestic ones, to sell out of Russia to avoid currency losses thus exacerbating the capital flight. This process also caused a slow bloodletting of the country's foreign exchange reserves, which fell by roughly 35% or US $200-billion.

The currency has stabilized in recent weeks and the central bank has successfully defended the lower value it has set for the ruble, although futures markets are still predicting an 18% decline this year.

At this point, investors may want to look to Russia and its highly cheap energy assets and buy in very cheaply for long run expected appreciation.