Emerging Markets Weekly

The end of the easing cycle of monetary policy appears to be upon us in China and India, months or perhaps more than a year before the developed market tightening cycle begins. India and China enacted very aggressive monetary policies beginning late 2008 to combat the global economic recession. Those policies have achieved a high degree of success achieving measurable growth rebounds. Policies will now start to transition from growth stimulus to inflation control.

Inflation in the emerging markets peaked in the summer of 2008 with the collapse of the global economy and the plummet in oil prices. The fall in inflation allowed central bankers to focus exclusively on growth. Policy rates were lowered aggressively across the emerging markets with the exception of some countries that had significant capital flight.

Investors should expect that interest rate cuts in India and China have run their course and that a focus on inflation will rise to the fore in 2010. In China, very loose monetary policy has led to exceptionally strong credit and money supply growth. While this outcome is not a visible concern for authorities, lending rates clearly needs to be reined in over the next year.



Inflation is now rising on a monthly basis even if it is still falling on year over year comparisons in China. What this means is that inflation pressures are only just starting to rise, and it will be several months before inflation rises on a yearly basis. Nevertheless, the fact that inflation has bottomed suggests that interest rate cuts have now reached their conclusion. Recent reports that China's two largest state owned banks announced limits on new loans for 2009 supports this claim.

In India, the Reserve Bank of India stated in its July 28th monetary policy statement that industrial production activity is picking up and that inflation concerns were starting to surface. Similar to China, annual inflation is negative, but monthly inflation is beginning to rise.

We view these developments positively because they confirm that the global economic recovery is happening in the emerging world. We also believe that the pick up in pricing power will lead to an earnings recovery in the near term. It is too early to begin fretting about tightening policy because inflation is only just bottoming, but we are following these developments over the next six months with a watchful eye.

Emerging Markets Weekly

The Russian economy has endured a deep recession in 2009 as a result of the global credit crisis. The stock market has sold off heavily as a result and since recovered with very strong gains. Yet it is still highly undervalued and an opportunity for investors with patient money who can wait two years at a minimum for a return to healthy growth.

What started as a lack of liquidity in the banking sector in 2008 has led to a widespread and deep recession in Russia. A sharp contraction in household consumption—the main source of growth in Russia in recent years—has been caused by rising unemployment and weak consumer confidence.

There are signs that the Russian economy bottomed in June after a devastating fall in output of roughly 10% in the first half of the year. The sharp fall in private consumption expenditure has been exceeded by a drop in investment and a rundown in inventories.

The fact that inventories have contracted suggests that as in the developed world, the fall in output exceeded even the fall in demand and bodes well for a period of growth due to restocking. Household consumption contracted 2.2% in the first quarter of 2009 well beyond the 15.2% fall in fixed capital investment in the first quarter.

The Central Bank of Russia (CBR) has steadied the ruble exchange rate since March when we first pointed out that Russian energy producers were dirt cheap (they have since rallied 70% or more). The CBR raised interest rates (since lowered on weak inflation reports) and ended the capital flight that occurred in the first two months of the year

The rise in oil prices is a very positive development for the country’s finances and bodes well for long term value of the ruble and for government finances. Investors should now expect slow and steady ruble depreciation over the next year.

Russia is expected to transfer US$43.7-billion out of its Reserve Fund, a sovereign wealth fund funded by petrodollar revenues, to funds its first budget deficit in a decade, that is expected to clock in at 8% of GDP in 2009.

Russia remains a viable long term investment opportunity due to its large energy reserves, sizeable foreign exchange reserves and long term potential rate of output. Its economy will return to modest growth in 2010 and is likely to recover more strongly by 2011. Its stock market is highly undervalued-- trading at around half the valuation of the other BRIC markets.

Emerging Markets Weekly

Investors fretting about rising valuations in China need to recognize that valuations typically rise at the beginning of economic recovery. Typically earnings eventually catch up to rising prices as the economic recovery takes shape. The 80% rise in the MSCI China index since October is in fact underpinned by rising earnings that are likely to catch up to the rise in prices over the next couple years.

Government stimulus measures are clearly working and leading to a major ramp up in analysts' twelve-month forward earnings estimates in China. Earnings in utilities, technology and industrial sectors are expected to rise 125%, 78% and 41.7% respectively over the next year.

The rise in share prices is clearly outpacing earnings, however, and valuations suggest the market is no longer cheap. This analysis is deceiving because prices tend to predict earnings recoveries leading to rising valuations at the start of an economic recovery.

The MSCI China index appreciated strongly in 2003 when the global economy recovered from recession, taking its P/E ratio to around current levels. A subsequent earnings rally allowed equity prices to continue rise, more than doubling between 2004 and 2007, yet valuations were no higher at the end of that period.

The P/E ration on the MSCI China index at 16.74 is below the level it reached in February 2004 after the market had also risen on the back of economic recovery. Investors who sold out of the market at that point would have missed a doubling in the index over the next three years. The interesting point to note is the P/E ratio was no higher three years later than it was in February 2004.

The MSCI China Index peaked in October 2007 at a P/E ratio of over 30. Clearly we are nowhere near overvalued territory today.

Emerging Markets Weekly

Investors interested in the contrasts between India and China on the one hand and the US on the other might consider the vastly different economic consequences of the current credit crisis.

Growth prospects are the first place to start with the contrast overwhelmingly wide. The World Bank forecasts GDP growth for India and China this year at 5% and 6.5% respectively and rising to 8% and 7.5% respectively in 2010. In a study of contrasts, the U.S. economy will contract at a 3% rate in 2009 and rise 1.8% in 2010. Similarly, industrial production will rise 7.4% in 2009 yet contract at a 12.5% rate this year in the U.S.



Retail sales have risen strongly in China in 2009 at a 17% annual rate of change. In contrast, retail sales in the U.S. have fallen sharply for the first time in decades. American consumers have hit a debt wall with little prospect for recovery in the near term.





One of the more interesting developments is the rise in emerging market bond yields versus the rise in high yield bonds in the United States. In the last U.S. economic recession, bond yields spiked up across all risk assets high yield bonds and emerging market bonds alike. This time around, emerging market bond yields (EMBI) have not risen in lockstep with high yield bonds indicating that sovereign borrowers in the likes of India and China are far less risky this time.



The near term credit crunch is a study of contrasts and looks likely to expedite the long term convergence of emerging markets to developed market standards. Mortgage penetration for example is very low in India and China, 8% of GDP and 13% of GDP respectively. Mortgage penetration in the U.S. at 82% of GDP has obviously gone beyond all measures of sound economic policy.

As credit rises in the India and China, for example, the financial sector will be a prime beneficiary. Credit on the other hand continues to contract in the U.S. economy and will likely do so for the next year or two.