Emerging market recovery – Silver lining slides into sight

The jury is still out on the strength and timing of the emerging market recovery. Despite the fallout from the Argentine debt crisis, the war on terrorism and slower global economic growth, Latin American and Eastern Europe/Middle East/Africa (EMEA) emerging markets are set to perform well in 2002.

“Normally, emerging markets recover earlier and stronger than developed markets coming out of a recession,” says Vincent Fernandez, vice president of Altamira Management Ltd. and manager of the Altamira Global Discovery Fund. In addition to the recovery in domestic demand, they get additional stimulus as the pickup in activity in the industrialized world boosts their exports.

However, the fundamentals that support optimism for emerging markets are shrouded in uncertainty. While statistical evidence indicates that global economic growth is set to pick up in 2002, the jury is still out on the strength and the timing of the expected recovery.

“Low interest rates, high liquidity and signs of a U.S. recovery will buoy investor confidence in the early part of the year, driving emerging-market stocks significantly higher,” Fernandez says.

On the other hand, Ricardo Barbieri-Hermitte, managing director and head of EMEA economics and strategy at New York-based Morgan Stanley Capital International Inc., forecasts that a strong U.S. recovery will not come until the second half of the year. “The U.S. economy is expected to contract further in the first quarter of 2002, recover hesitantly in the second quarter and strongly in the second half of the year,” Barbieri-Hermitte says. He expects European growth will follow a similar pattern but with less contraction in the first quarter and stronger growth in the second half.

Whatever the timing, a key factor for emerging markets will be the strength of the U.S. recovery. According to a report by New York-based Merrill Lynch & Co. Inc. entitled “The Global Emerging Markets Crystal Ball — What’s Emerging in 2002”: “Ironically, modest global economic recovery might help emerging markets more than vigorous recovery, to the extent that it will prompt global investors to re-think long-term growth prospects across the globe and perhaps question the bullish long-term story.”

The risk, the report suggests, is that should the U.S. recovery be stronger than anticipated, investors may prefer to stay closer to home, avoiding the greater risk associated with emerging markets.

Probably the best news for the regions is the waning of the risk of a contagion effect from Argentina’s debt crisis, which was overhanging Latin American markets for much of the last quarter of 2001.

As the crisis unfolded, investors worried about a contagion similar to the Mexican peso crisis, the Russian ruble crisis, the Asian currency crisis and the Brazilian real crisis. Particularly vulnerable, analysts felt, were Brazil, which is highly dependent on capital flows, and EMEA countries such as the Czech Republic, Poland and Hungary, which have large current-account financing requirements.

However, when Argentina defaulted on its US$132-billion debt on Dec. 23, there was no sign of contagion. Analysts say there are two reasons. First, the crisis did not come as a surprise, giving money managers time to prepare for potential fallout. “Argentina’s debt problem did not creep up on investors. It was not a surprise and, consequently, did not cause the same degree of fallout as the Mexican or Russian crises,” Fernandez says.

Second, currency regimes in many emerging markets have become more flexible since the Asian crisis, providing a cushion for external shocks.

Even if the Argentine crisis comes back to haunt emerging markets in 2002, the fallout is not expected to be lengthy. Kent Hargis, emerging-market strategist with Goldman Sachs Group Inc. in New York, says: “Our analysis of previous emerging-market crises indicates the duration of the decline following devaluations in Mexico, Brazil, Russia and Asia varied from one week to three months. We expect the duration of any market decline to be on the shorter end of this range due to the anticipated nature of the crisis.”

The other variable is the war on terrorism. So far, the war has not had much effect and may not do so in 2002. “Security is an issue that most emerging markets have had to deal with for a long time,” says Fernandez. “While terrorism is not expected to have a direct impact on emerging markets, it can slow down movement of goods — for example, cross-border trucking between the U.S. and Mexico.”

Assuming a V-shaped global economic recovery, Hargis recommends investing in countries and sectors with low valuations and domestic catalysts — including financials, telecoms and utilities — which “tend to outperform in the transition to growth and when risk aversion declines.”

The GS portfolio is overweighted in upstream foundry (semiconductor factories) and dynamic random access memory semiconductors, and underweighted in downstream technology such as components and tech services. It is also underweighted in energy stocks — Hargis believes production cuts will be overshadowed by warmer weather — and the mining sector, which is experiencing pricing pressures due to high inventories. Brazil and South Africa are overweighted because Hargis believes high levels of risk are already priced into these markets. In Brazil, he’s overweighted in utilities and underweighted in consumer staples.

Fernandez favours firms that “are sensitive to export growth, including technology.” He is also overweighted in stocks that are “levered to domestic consumption,” such as beverages, retailing and telecoms.

With Mexico’s growth directly linked to a U.S. recovery, Fernandez has it underweighted but says he may increase his exposure later in the year as the full economic picture becomes clearer. He is neutral on Brazil, which he believes is “extremely cheap” and has a declining risk premium. He will keep an eye on the general elections later this year, which could raise political risk.

Emerging markets can be full of surprises. But with less than 2% of Canadian investment funds flowing into EMEA and Latin American markets, the risks taken in these markets should not significantly affect total investments.

Argentina’s problems run deep

Argentina is probably not at the top of the shopping lists of investors looking for opportunities in emerging markets in 2002. The country is mired in economic, political and social problems. The economy is now in its fourth year of contraction, with real gross domestic product expected to decline by 6% this year. In the two weeks following Dec. 20, it changed presidents four times amid violent civil unrest. The current president, Eduardo Duhalde, is already under fire for being a part of the “old guard” responsible for the present state of affairs.

Argentina’s problems are deep and varied. It has a history of corruption, economic mismanagement and patchwork fiscal and monetary policies. Faced with a widening budget deficit, the country passed a zero-deficit law in July 2000, requiring cutbacks in public spending, the impact of which has been exacerbated by declining tax revenue and a bloated public sector. Unemployment stands at about 20%.

The IMF has bailed out Argentina nine times since 1993, each time prescribing its usual deadly cocktail of higher taxes and fiscal austerity. As the country gasped for breath in early December, the IMF pulled the plug on the disbursement of US$1.3 billion in assistance for failure to meet fiscal targets, causing panic.

As a result, Argentina, the largest emerging-market debtor, defaulted on US$132 billion in debt on Dec. 23. With its currency pegged to the U.S. dollar, Argentina had the option to devalue, dollarize or default. Dollarization is a virtual impossibility because under the convertibility plan established in 1991 — when it pegged the peso to the US$ at a one-to-one ratio to fight off four-digit inflation —the country needs US$1 in reserve for every peso.

Although the former Argentine government avoided devaluation, Duhalde’s decision in early January to unpeg the peso from the US$ will effectively devalue the currency by 30%-40%. This will place additional burdens on Argentines, whose mortgages and loans are denominated in US$ while wages are in pesos. Payments will skyrocket and savings will be wiped out, making them as bankrupt as the country they live in. IE

Dwarka Lakhan

Dwarka Lakhan is a pioneer in emerging markets journalism in Canada. His first emerging markets article, “Africa Joins Ranks of the Emerging,” appeared in Investment Executive, Canada’s leading newspaper for financial advisors, in September 1994. Since then he has written hundreds of articles on the full spectrum of emerging markets and has conducted more than two thousand interviews with emerging and frontier markets investment professionals.

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