How global dynamics could impact equities

cific region is expected to account for over 90 per cent of total equity portfolio flows to emerging market countries this year.  In China net inflows could increase this year to $15 billion from $12 billion in 2004. Inflows could be constrained by concerns over corporate governance and the true state of firms' balance-sheets, as well as the general health of the financial system.  In emerging Europe, net portfolio equity investment is expected to decrease this year to $5.5 billion from more than $7 billion in 2004.  Latin America is expected to show a net outflow of portfolio equity investment of $4 billion in 2005, following an outflow of $7 billion last year; Chile will account for the bulk of outflows. There is also expected to be a slowdown in total financial flows to emerging countries this year.  Growth to drive performance?
Factors that may work in favour of emerging markets are the growth in the respective countries.  According to IIF estimates, growth in 2005 across regions is expected to slow down with Latin-America posting a GDP growth of 3.9 per cent from 5.7 per cent in 2004; Europe is expected to grow at 5.2 per cent from 6.7 per cent while Asia-Pacific is expected to grow at 6.9 per cent from 7.3 per cent. 
 

GDP growth GDP growth rate (%) in emerging economies continues to be strong
Regions	2005f	2004e
Latin America	3.9	5.7
Europe	5.2	6.7
Africa/Middle East	4.1	4
Asia/Pacific	6.9	7.3
Countries
China	9.5	9.5
India	8	6.9
Korea	4	4.7
Thailand	4.5	6.1
Source: IIF

 China is largely expected to grow at a similar pace - 9.5 per cent - while India is ahead of the pack with a forecast growth of 8 per cent against 6.9 per cent.  Consequently, valuations in the Asian markets look attractive. Based on FY06 earnings estimate, India (12 times) and China (10 times) still look cheap and cheaper compared to others.  Will this ensure more fund flows to the region and better stock market performance? While emerging economies are still outpacing developed markets in terms of economic growth and the structural story as well as the equity valuation look attractive, the performance of equities in emerging markets may still be linked to that of the developed markets.  In the debt markets, emerging markets and developed markets are showing some signs of decoupling. There has been a widening gap between US high risk bond (junk) yields and emerging market yields. After the S&P downgraded General Motors and Ford Motors to junk, US junk bond yields have risen while emerging market yields have not moved as much.  The yield on US junk bonds, which are perceived to carry the same risk as that of emerging market bonds, has risen over 60 basis points in the last three months to about 8.3 per cent while emerging market yields remained lower at about 4 per cent.  That the two have not moved in tandem implies decoupling. Could this happen in equities also? Chetan Sehgal, portfolio manager, Templeton Emerging Markets Group, rules out the possibility of a decoupling.  "As companies become more and more global, the linkages will get stronger, diminishing the chances of a de-coupling," he says.  

Other worries

There are three significant worries stemming from global markets. A) Could commodity prices come crashing in the event of a Chinese slowdown? B) Could continued rise in oil prices impede growth and depress profitability? C) What would the re-valuation of the Renminbi mean for markets? Here is a brief look at how each of these factors will play out.

Commodity prices: Commodity prices are ruling at all-time highs. If the cycle turns, commodity companies will face cost pressures and lower realisations. Commodities may be in a long-term secular bull market but the cyclical outlook is bearish, according to BCA Research, an investment research firm based in Canada.

"In commodities, long-term peaks have been achieved, supply and production have gone up, demand is drying and therefore prices are bound to fall," says Sehgal.

Futures prices of non-ferrous metals on the London Metal Exchange (LME) are already trading at a discount to their spot since the beginning of the year. With global growth having moderated and the Chinese authorities continuing to rein in the pace of capital spending, commodities may well be something to steer clear of.

However, a fall in commodity prices may spell good news in the form of easing pressure on raw material prices and hence profit margins of user-industries.

Oil prices: Oil prices still remain a cause of concern as it could increase corporate costs, depress earnings apart from seeping in inflation into the global economy. The Brent crude oil price has increased 35 per cent to levels of $49.61 per barrel.

This is even after a drop of 11 per cent from levels of $56 that it touched in mid-March this year. While there are reports of oil surging ahead to levels of $60 (even $100) a barrel, there has been some respite with supple concerns easing.

"Despite global inflationary pressures easing, oil prices may send in bouts of pressure which remains a worrying factor," says Sehgal.

Revaluation of the Renminbi: US wants China to revalue its currency by at least 10 per cent to aid the US curb its burgeoning trade deficit.

However, according to Merrill Lynch's Asia-Pacific's economics team, China's trade surplus with the US is unlikely to fall much. A surprise revaluation may be in store, according to experts. The denial by Chinese officials has been seen as a move to curb speculative activities. China will sooner or later yield to pressures from the US, say experts.

According to BCA, a higher Renminbi is not expected to have any major impact on other Asian currencies as the revaluation news is already factored. So, the revaluation will not bring about any significant economic benefit to the Asian countries.

However, a revaluation of Renminbi will bring a logical appreciation in Asian currencies, too, reducing their competitive edge.