Reset the clock on emerging markets

Related topics: stocks, emerging markets, China, Brazil, Jim Jubak

So where's the bottom in emerging-market stocks? Or, if picking the absolute bottom is too hard (and it is most of the time), when is enough risk out of these stocks to justify some serious bargain hunting?

Emerging-market stocks have had the "emerging" beaten out of them in the last month. Brazil's Bovespa index is down 7.8% from the April 5 local high to the close on May 6. India's Sensex 30 index is down 6% from its April 4 high to the close on May 6. China's Shanghai Composite index is down 6.3% from its high on April 18 to the close on May 6.

But this recent drop is just an accelerated version of the decline that most of these markets have suffered since they peaked back in the first half of November. From those November highs, the Bovespa is down 10.4%, the Sensex is down 11.2% and the Shanghai Composite is down 9.0%.

Since the beginning of the year, I've been saying that the U.S. market will be the best-performing stock market in the world in the first half of 2011. And it has been, with the Standard & Poor's 500 Index ($INX) up 5.3%, even after the carnage of the last week.

But I've also been saying that investors should rotate into emerging-market stocks, beginning slowly in May or so, because those would outperform in the second half. On current performance, you're entitled to ask, "Oh, yeah? When?"

In the last few weeks I've been writing that "May or so" should definitely emphasize the "or so." Today's column is my attempt to explain why the timetable for rotating into emerging markets has slipped, but remains fundamentally intact -- and to give you some concrete guidelines for planning your rotation into emerging-market stocks.

What I thought would happen

First, a quick summary of everything I thought would soon fall into place to make emerging markets outperform:

1. Emerging-market central banks, which began fighting inflation before any of the Big Three developed economies started to raise interest rates, would have ended the chance of runaway inflation and be close to ending the current cycle of interest rate increases from Delhi to Brasilia.
2. Developed economies would just be starting a round of interest rate increases, designed to fight inflation, yes, but just as importantly, to normalize currently negative real interest rates somewhere above zero.
3. As emerging-economy central banks stopped raising interest rates, economic growth rates in those countries would start to move higher.
4. Rising interest rates in the eurozone and the United States would start to strengthen the euro and the dollar against emerging-market currencies, reducing the flows of hot money into these currencies and at least slowing the rate at which they appreciate against the dollar and the euro.
5. The end of worries about emerging-economy growth that comes with the end of the interest-rate-tightening cycle would stabilize commodity prices in an upward trend, but the move would be moderated by gains in the dollar. Commodity-driven emerging markets would show less volatility.

Nothing ever works out as perfectly and in such an orderly way as that scenario. It's just a question of whether the deviations are so great that we need to junk the whole scenario and go back to the drawing board -- or if we just need to make some modifications in a structure that still hangs together. I believe the latter is the case in this emerging-market scenario. The timing certainly needs modification, but the trends still run in the direction I've described.

What's changed?

1. Emerging-economy central banks blinked when the time came to really stomp on inflation. For example, in Brazil, the Banco Central do Brasil imposed a 0.25 percentage point increase in interest rates when the financial markets were thinking that an increase of 0.5 percentage points was necessary. That undermined the bank's credibility on inflation and stretched out the rate increase cycle.
2. Some emerging-economy central banks remain convinced that they can get away with fewer interest rate increases or none at all by supplementing (as in the case of China) or replacing rate increases with higher bank reserve requirements (Turkey), credit restrictions, and price controls (China again). Nobody is sure if these measures will work, but the financial markets have doubts. This, too, drags out the interest rate cycle.
3. U.S. fiscal policy has been so irresponsible that it has delayed any move by the Federal Reserve -- except the politically necessary one to end quantitative easing in June -- that might slow the U.S. economy. The U.S. central bank is doing everything it can, reminding Wall Street that it will keep buying Treasurys when current investments mature, for example, to convince financial markets that it will continue a pro-growth monetary policy. Of course, the financial markets aren't convinced; they know how little wiggle room the Fed has left with interest rates at 0%. But you can't say the Fed isn't trying. And it has managed to convince investors that the beginning of U.S. interest rate increases are further out than anticipated at the beginning of 2011.
4. Nobody expected a wave of revolutions in the Arab world that would remind commodity markets of exactly how little spare capacity oil producers have. The rise in oil prices helped lead commodity prices in general higher, and that has fed into global inflation and inflation expectations.
5. The European Central Bank is trying desperately to live up to the inflation-fighting image of the old Bundesbank, but the euro crisis keeps getting in the way. The bank would be a lot further down the rate-increase road if Portugal and Greece didn't keep getting in the way. And if the European Central Bank had already raised rates two or three times by now, instead of just once, who knows if the U.S. Federal Reserve could have resisted the pressure -- or the even greater plunge in the dollar -- to follow and put an interest rate increase on the books for 2011?

What we're left with, after reality has so rudely dealt with my ideal scenario, is a combination that I'd call splintering delay: All the emerging markets are going to take longer to reach their interest rate cycle turning points, and some are going to take far longer than others.

A closer look at Brazil, China and India

Brazil, for example, which looked at one point like its current interest rate cycle would top out at 12%, perhaps as early as this fall, now looks headed for a top benchmark interest rate of 13%, or even 13.25%, by the end of 2011. The central bank is still predicting that month-to-month inflation growth will start to slow in May and that 12% is a likely top. But that forecast is widely seen as part of the problem: The central bank is too optimistic and therefore moving too slowly, the financial markets concluded after the bank raised rates just 0.25 percentage points in April.

But Brazil seems to be on the inflation/interest-rate-cycle fast track when compared with China. Beijing seems to have moved in recent months from fighting inflation to fighting the perception of inflation -- see last Friday's fine of 2 million yuan ($308,000) against Unilever (UL, news) for talking about plans to raise prices. Panic buying hit Shanghai, Beijing and other cities when government media announced that the four companies that dominate the detergent market -- Procter & Gamble (PG, news), Guangzhou Liby Enterprise Group, Nice Group and Unilever were planning to raise prices by as much as 15%. So far, only Unilever has been hit with a fine.

As politically popular as price controls, government-run low-price grocery stores, ad hoc reversal of transportation fees and surcharges, and the public humiliation of companies that dare even think about raising prices may be, all these measures are really just delaying tactics. They postpone the day when inflation hits home, but they don't reduce the causes of inflation. They're worth implementing if they buy time while the government tackles the root causes of inflation -- in the case of China, such thorny problems as an undervalued currency and negative interest rates for bank depositors.

They're actually harmful, however, if they wind up being regarded as substitutes for hard choices that might slow the economy and throw some Chinese out of work. In that case, these policies actually make inflation worse by delaying significant action and lead to the need for more drastic policies in the future.