Emerging Markets: Is It Time to Cash In?

Knowledge@Wharton editor's note: Most emerging market economies are unlikely to de-couple from the U.S., a premise behind the sharp, brief rally in emerging stock markets last fall. Since the American economy and stock market started weakening in late 2007, so have most emerging markets. Some developing countries may provide short-term investment gains due to specific economic factors. Are these increases sustainable? In this opinion piece, Ignatius Chithelen, managing partner of Banyan Tree Capital Management, an investment firm in New York City, argues that with most gains from emerging stock markets already behind us, it may be time to sell.

Since the summer of 2007, numerous signs of speculative excess have appeared in emerging markets: Stocks in Shanghai and Shenzhen trading at 100% plus premiums to the prices at which the same Chinese stocks trade on the Hong Kong Exchange; reports of Chinese peasants pawning homes to buy stocks; frenzied bidding for IPOs in India of companies with no revenues and earnings; and commercial and residential real estate prices in major emerging market financial centers exceeding those in New York.

But the day the U.S. Federal Reserve began cutting rates last August, in an effort to tackle the growing subprime mortgage mess, some investment advisors and speculators identified emerging stock markets -- and commodities -- as major beneficiaries of the Fed's action. These strategists argued that a slowing U.S. economy would have little impact on emerging countries. The reason was that trade among these fast-growing countries was sizeable, they had large and growing domestic consumption, and they had benefited from the booming worldwide demand for commodities. Further, unlike during the last series of crises in emerging markets in the 1990s, these economies were now in good financial shape. They collectively had a current account surplus of more than $600 billion a year, and their total foreign exchange reserves exceeded $2.7 trillion. The speculators, meanwhile, rushed in with the belief that the liquidity generated by the Fed rate cuts would create yet another bubble, this time in emerging markets and commodities.

In just seven weeks following the Fed's August 2007 discount rate cut, institutions and individuals in the U.S. poured an estimated $24 billion into emerging equity markets. This was $1 billion more than the funds that flowed in during all of 2006, and the emerging markets moved up sharply. The iShares MSCI Emerging Markets Index Fund (EEM Quote), a New York Stock Exchange-traded fund (ETF) that is representative of the MSCI Emerging Markets Index, climbed about 50% in less than two months, from late August to late October. But since then, as the U.S. economy and stock market have weakened, so have most emerging markets -- the EEM is down about 20%. ...