NEW YORK (TheStreet) -- The former Deutsche Bank strategist who predicted a crash in emerging-market stocks as early as 2010 says there are further declines ahead as China faces a ``slow-motion'' financial crisis and banks in India, Russia, Brazil, Korea and Poland face growing loan losses.
John-Paul Smith, who accurately forecast Russia's stock market crash in 1998, wrote in an Aug. 25 note to clients that they should avoid China altogether and that stocks from other developing countries still look expensive. The call comes even after the MSCI Emerging Market index, a gauge used by many money managers, tumbled this month to a six-year low.
"I'm telling clients to avoid emerging markets completely, to hold cash or cash equivalents wherever possible," Smith, who left Deutsche Bank last year to start an independent research firm, Ecstrat, said in an interview. "I can see reasons why we might stabilize in the short-term, but would I personally go back into emerging markets at the present? Absolutely not."
The Chinese government's inability to stave off market declines has combined with a corruption scandal in Brazil and falling commodity prices to drive down stocks across developing countries, until recently prized by investors for their higher yields as the U.S. and Europe cut benchmark interest rates close to zero. Smith's call adds to a chorus of bearish emerging-market investors, including Franklin Templeton Investments' Mark Mobius, who told Bloomberg Television this week that he is "sitting on cash."
The MSCI EM index has lost 18% this year, about triple the 6% loss in the S&P 500 Index (SPY) . The Dow Jones Industrial Average has dropped 9% in the same period.
While falling prices for oil and commodities have hit raw-materials producers, many developing countries have failed to take the necessary steps to shore up long-term economic growth and make tough fiscal decisions, says Stuart Quint, senior investment manager and international strategist for Brinker Capital, a Berwyn, Pa.-based firm that oversees $18.5 billion. For example, he said, Brazil's lower house of Congress approved a measure in June to raise pension expenditures in coming years, even though the country is in a recession.
BlackRock's iShares MSCI Brazil Capped exchange-traded fund is down 32% year-to-date.
"In many of these markets, growth has slowed down, partly because of the commodity cycle, and you've had a big credit expansion in the banking system, but not enough structural reforms to keep it going," Quint said in an interview.
Even in India, which as a net commodity importer should outperform peers, stocks will "not necessarily go up"' because it's part of the "emerging-market asset class" and thus vulnerable to capital outflows, Quint says.
According to a report from the Swiss bank UBS on Aug. 24, emerging-market stocks are headed for their seventh-worst month in 19 years. Investors have pulled $38.2 billion from developing countries so far this year, just shy of the $39 billion withdrawn in all of 2008, during the financial crisis, UBS said, citing research firm EPFR Global.
While UBS believes its year-end target for the MSCI EM index is now "out of reach," analyst Geoffrey Dennis said in an interview that the "the next 10% move is up, not down.'' Indian stocks look attractive because they're isolated from China, he says; UBS is also overweight Poland because it's a beneficiary of lower oil prices and Mexico because it's tied to the U.S. economy, according to Dennis. Oil prices have fallen by 57% in the past year, while copper is down 31%.
Tim Love, London-based investment director for the $135 billion fund manager GAM, says he likes growth stocks in countries that have proven less correlated with the benchmark index. Picks include Sun Pharmaceutical Industries Ltd. and Asian Paints Ltd. (ASNQY) , both based in Mumbai.
The MSCI EM Index's price-to-estimated-growth ratio is close to 1, he said. Compare that with 2.2 times for McDonald's Corp., which Love cited as an example of a globally diversified growth stock watched by many U.S. investors.
For emerging stocks overall, "maybe there's 10 percent downside from here, but your upside could be 50 to 80 percent over the next two to three years," Love said.
Whatever happens with emerging-market stocks overall will ultimately turn on China as well as the U.S. Federal Reserve's determination to raise interest rates, which would reduce the appeal of higher-yielding assets elsewhere, says Nicholas Smithie, chief investment strategist at Emerging Global Advisors. The New York-based firm oversees $1.6 billion.
"There is a good likelihood that the emerging-market index might continue to fall, reflecting lack of growth, weak currencies and lack of confidence," Smithie says.
Ecstrat's Smith, who also previously worked at Pictet Asset Management and Morgan Stanley, says stocks from countries perceived to have better governance, including Mexico, India, the Philippines and South Africa, are getting higher valuations than those from China, Russia, Brazil and South Korea. That said, the standouts probably will come under selling pressure "on the back of further redemptions from EM funds," he wrote in his Aug. 25 report.
Retail investors are starting to cash out, and U.S. pension funds are likely to follow, he said in the interview. That's especially true now that five-year returns have turned negative for stocks from less-developed countries, Smith said. His firm advises sovereign wealth funds as well as U.S. and European money managers.
"A lot of big pension funds have gone into emerging-market equities on the back of spurious arguments from very highly paid consultants that emerging markets are the better long-term prospect, and it's nonsense," Smith said. "These people will start to reconsider their commitment when they pick up the newspaper and see that the Chinese economy is in serious difficulty. Then they and their highly-paid consultants will come around to the fact that maybe this wasn't such a great idea."