Global Unrest and China, Not Fed, Threaten Emerging Markets: Deutsche Bank

NEW YORK ( TheStreet) -- Turmoil in the Chinese economy and populist pressures in other emerging markets, rather than U.S. interest rates, are likely to drive performance for emerging markets stocks over the longer term, according to recent research from Deutsche Bank.

Deutsche Bank strategists led by John-Paul Smith believe political unrest in many developing countries, which they call "governance concerns," as well a major overhaul of Chinese government institutions, will cause emerging markets assets to underperform those of developed countries for the foreseeable future.

"The lack of visibility surrounding future possible actions by the Chinese authorities to reform the economy, will engender further volatility for financial markets and will eventually cause some longer term investors to question their commitment to the global emerging markets asset class," Smith writes. His views echo those of Goldman Sachs economists, who recently downgraded their view on emerging markets.

While emerging markets stocks handily outperformed those of developed markets for a decade beginning roughly in 2000, they began to lag in late 2010. Starting Sept. 24, 2010, iShares MSCI Emerging Markets Index ( EEM), a popular emerging markets exchange-traded fund, has lost 12.50%, while the S&P 500 has gained about 43% over the same time period. Year to date, with the S&P up 13%, EEM is down more than 15%.

When Fed Chairman Ben Bernanke ignited a market selloff June 19 by stating the Federal Reserve could begin reducing its $85 billion in monthly bond purchases this year, emerging markets stocks fell even more sharply than the S&P, as EEM lost 7.41% vs. 3.81% for the S&P from June 19-20.

Smith argues the latest emerging markets selloff was actually ignited by earlier statements by Bernanke May 22. Regardless, the real factor of late has been the inaction of the People's Bank of China in the face of market panic. Even as overnight interbank lending rates shot up from 3% to anywhere between 12% ( Bloomberg) to 25%( The Economist) on June 20, the Chinese central bank did nothing to ease the liquidity squeeze.

Deutsche Bank's strategists view the PBoC's inaction as only the latest indication that "the authorities in China face an almost insurmountable task to restore historic rates of productivity growth" due to "very blurred boundaries which exist between the state and private sector which distort capital allocation" among large businesses. They only long-term solution, they argue, is "a complete overhaul of the fiscal relationship between local and central government, which would also involve wholesale changes to the fundamentals of land ownership."

In other emerging economies, including Malaysia, Chile, Russia, Brazil and Turkey, Deutsche Bank's Smith sees political unrest pushing governments "further towards populist policies, which will accentuate the transfer of resources away from the corporate sector, thus further undermining longer term economic growth prospects." He argues emerging markets countries "are more vulnerable to these pressures than their developed markets peers because of the generally less well developed institutional and legal infrastructure as well as lower output gaps."

Despite his long-term bearish view, Smith sees short-term opportunities since emerging markets assets have sold off so sharply of late. He is overweight Mexico, Turkey Poland and Taiwan. "which combine cheap currencies and/or high dividend yields, with governance at a sovereign and corporate level, which is at the very least not obviously deteriorating."

While he sees Brazil and Russia as "so unloved by investors that they are candidates for the 'it's so bad, it's good' club," he nonetheless remains underweight, "since governance at the sovereign and corporate level is still moving in the wrong direction." Deutsche Bank is also underweight China "obviously," and in Korea, "where we are becoming a little less bearish."

-- Written by Dan Freed in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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