Parallels with history suggest emerging markets are ‘close to the bottom’

Peter Eerdmans, Head of Emerging Market Debt at Investec Asset Management, reflects on the outlook for emerging markets by drawing parallels with historic crises

Emerging markets are certainly entering a more challenging time. We expect growth in emerging markets to slow sharply in 2009 and current accounts to deteriorate as exports slow and commodity prices stay depressed. One offset is that inflation is likely to fall sharply, thereby improving disposable income of consumers.

The question is, how much of all this is already priced into the markets?

‘Past performance is no guarantee of future returns’. The well-know strap-line that accompanies every marketing brochure in the investment world offers investors some wise words of caution, but we can draw from historic crises to decide on the most likely future path out of the current crisis.

Firstly, markets bottom long before the real economy does. Markets will price in the expected events over the next say 6-12 months. Just as markets can fall very sharply on fear or expectations of a recession (rather than waiting for confirmation of a recession), markets will also look through difficult economic times, starting to price in the recovery long before it happens in the real economy. As such, markets can be forecasters of real economic activity, much more so than the other way around.

To underline this point, let’s look at the Asian crisis back in 1997/1998. The hardest hit countries in the region entered a multi-year recession, but their currencies were only weak for a period of 6-12 months. Currencies started falling sharply from the third quarter of 1997 and reached their lows at the start of 1998. By the time the currency bottomed in early 1998, the worst was yet to come in terms of economic activity. In fact, Asian growth rates didn’t turn positive until a year later in 1999.

What about the severity of the current sell-offs in the context of the two key, comparable crises: the Asian crisis of 1997 and the Russian default/LTCM crisis of 1998? The first was more a currency crisis caused by classic balance of payment problems, while the second centred more around credit risks as Russia defaulted on its obligations.

Currently, it seems that we are facing both a credit and a currency crisis.

During the second half of 1997, the key emerging market currency index (JP Morgan’s ELMI+) lost 18% over a period of six months in US dollar terms. In the current crisis this same index is down 19% in the past three and a half months. In the Russian crisis, the emerging market dollar bond index (JP Morgan’s EMBI) lost 32% over a period of six months (with the bulk of the sell-off concentrated in the last month of this period). This index has currently lost 30%, with the bulk of the move in October.

The above numbers suggest we could be very close to the bottom. The moves are of similar magnitude and similar size. Of course, things are never exactly the same. On one hand, the current crisis is more challenging, as the G7 countries are heading for recession, whereas the G7 was in better shape during the 1997-1998 episodes. On the other hand, emerging markets are much stronger now than ten years ago. Forex reserves, current accounts, reliance on external flows and the fiscal situation all score much better on average across the emerging markets world now.

Timing the bottom well, can, of course, lead to very strong investment returns. If an investor had bought a basket of EM currencies (JP Morgan EMLI+ index) at the bottom of the Asian crisis, he would have made 27% in the next 12 months and over 13% per annum in the subsequent three years.

In conclusion, a comparison with historic crises does suggest we could be close to the bottom. History also shows that markets don’t ‘wait’ for the bottom in economic activity, rather they will start pricing in the turn ahead of when it actually happens. On this basis, we would certainly caution against becoming too bearish now. In our portfolios we will most likely be looking add to positions in the weeks to come.