by Ivan Martchev | June 18, 2012 10:54 am
The 15% slide in the MSCI BRIC Index during the past three months has caused concern that more losses might be coming in stocks of the four largest emerging economies.
This is nothing new in the sense that they always have been more volatile than developed markets, as they are much smaller by capitalization and easier to move. In an environment where massive outflow of capital from important parts of Europe has pushed German and U.S. sovereign yields to all-time lows, it is normal to see “more risky” assets like emerging-market equities get marked down in price.
It has to be noted that the selloff also is being pushed by the long-term trend of rising correlations not only between global stock markets, but also between different asset classes like commodities and bonds. Without going into details, we currently are near an all-time correlation high, above the extreme levels seen at the end of 2008. (This volatile year is relevant, as the correlation between global markets tends to rise sharply during global stock market selloffs. The statistical measure of correlation has been making a remarkably consistent series of higher highs at all major sell offs in the past 20 years. This is because of globalization, but also due to the rise of computerized trading.)
While rising global correlations are a fact of life, this does not mean investors cannot make money in BRIC markets over time.
Despite all the volatility, the MSCI BRIC Index has a 10-year annualized return of 13.28% in the past decade, while the MSCI World Index of only developed markets across the globe is up 2.57% during the same period. Many developed-world economies — most notably Japan, the U.K. and some PIIGS countries — have been operating on economic cycles driven by rising leverage ratios, both at the governmental and corporate level, and now they have begun to run into trouble. The large emerging BRIC economies, for all of their differences and local problems, still operate on savings and investment-driven economic cycles.
Government debt-to-GDP ratios for Brazil, Russia, India and China are 66.2%, 9.6%, 68.5% and 25.8%, respectively. For comparison, the U.S., eurozone and Japan have respective government debt-to-GDP ratios of 103%, 87.2% and 211.7%. Total debt-to-GDP ratios are much higher overall for both emerging and developed economies, but the BRICs’ total leverage still is a third or less of the total leverage ratios of most major developed economies.
After the 2009 financial crisis-driven contraction, Brazil’s economy rebounded to 9.3% year-over-year GDP growth in the first quarter of 2010. Since then, during the past seven quarters, the Brazilian economy has been progressively slowing down every quarter, recording GDP growth of only 0.8% in the first quarter of 2012.
While rising consumer spending has been a big driver of growth over the past decade, there are indications that consumers are tapped out, with vehicle sales falling 11% in April and rising defaults on car loans to 5.8%. Brazil also is somewhat boxed in by China, where growth also is slowing down, which will rub off negatively on Brazilian exports via the commodity-demand connection. Any further weakness from here catalyzed by the correlation to the European mess will give investors an opportunity to establish a position in Brazil via ETFs, like the Market Vectors Brazil Small-Cap ETF (NYSE:BRF) — a play on Brazilian consumers with no ADRs.
Russia is notoriously the most volatile of the BRICs because it has the highest economic exposure to energy and mineral prices. This has given it the most depressed valuation.
As bizarre as it might sound, the MSCI Russia Index now trades at a forward P/E of 3.85 and offers a dividend yield of 4.06%. The only other time I have seen this index have a higher dividend yield than its P/E ratio was in October 2008 (and this is the only index I have ever seen deliver such valuation metrics). This lasted only for a quarter or so as the dividends got cut — massively so — but it also was near a major market bottom. Now we have a similar depressed valuation despite considerably less economic stress in Russia than in 2008.
At $2.022 trillion, Russian GDP has long surpassed the levels of 2008, while share prices are about half of their 2008 high despite solid profit growth. While such a discount might get even bigger because of rising global stock market correlations, it will prove an opportunity if/when the European situation is resolved. Russian-focused ETFs include the Market Vectors Russia ETF (NYSE:RSX) and the Market Vectors Russia Small-Cap ETF (NYSE:RSXJ); the latter is more focused on the Russian consumer, with a third less energy exposure.
The same way the Brazilian economy has slowed down from the first quarter of 2010, the Indian economy has slowed down every quarter during that period to go from year-over-year GDP growth of 9.4% to the present 5.3% annual rate.
India is very different from the other BRICs as it is the only major emerging market driven by domestic demand and not exports. The current account deficit has reached a record $189.4 billion, or 3.7% of GDP, and still widening in the fiscal year ended March. India does not have a lot of oil, and fast economic growth puts pressure on its trade balance and results in a problematic inflation rate of 7%.
The combination of the above factors has caused the Indian rupee to weaken sharply to 55.85 to the dollar, which is a lot weaker than the 2008 exchange rate low. (All emerging-market currencies tend to retrench at times of rising financial stress, so the present “less stressful” INRUSD weakness is telling.) The fact remains that India has GDP per capita that is only a fraction of the other BRICs, which long-term investors should view as an opportunity. The Market Vectors India Small-Cap ETF (NYSE:SCIF) has been “bombed out” to trade at 0.9 discount to book value, which is typical in selloffs as the average weighted market cap is less than $500 million.
Finally, the largest of the BRICs — China — is the most problematic from an index or ETF perspective, because of my long-held view that this is not a market that should be played broadly.
In China, many companies still are not being run for the benefits of shareholders — mandated lending quotas for banks come to mind near the top of the list. Forced lending does create the necessary aggregate demand, but it also creates higher losses that can spiral out of control in the normal economic ebb and flow. Right now, Chinese economic data shows deceleration, and banking stocks trade near record low book values because of the above dynamic.
This is why I would rather watch the developments from the sidelines in the largest of the BRIC economies. China is a stock-picker’s market, where the individual companies can be considered as investments based on their merits and not because of how they are directed by local CPC officials.
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the aforementioned securities.
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