A Rougher Road for Emerging Market Stocks

After five years of strong gains, deteriorating fundamentals have led to profit taking in emerging market equities. But some regions are still outperforming

While emerging market (EM) economic momentum continues, we think decelerating growth in the United States, Europe, the United Kingdom, Canada, Japan, and other developed economies is giving rise to concerns that slowing export demand will pressure profit growth for emerging market multinationals.

In addition, the problems in the credit markets have made investors around the world more risk-averse and caused them to pare exposure to more volatile asset classes in general.

Strong demand and soaring commodity prices are fueling a major increase in EM inflation rates. According to Global Insight, an independent forecasting firm, overall EM CPI rose to 9.7% in May from only 5.1% a year ago. With EM per-capita incomes averaging only about $3,000 a year, food and energy expenditures comprise a much larger portion of consumer spending than in developed countries. We think this magnifies the impact of record commodity prices on overall inflation trends.

As a result, all four BRIC central banks are now raising bank reserve requirements and short-term interest rates to mitigate pricing pressure. In our view, this could put upward pressure on EM currencies, and not only undermine the countries' ability to compete around the world but could also lead to slowing economic and earnings growth.

We think rising EM bond spreads over U.S. Treasuries confirm these fears, reflecting increased concern about the sustainability of record EM gross domestic product (GDP) and corporate profit growth.

As such, we don't expect another year of strong EM equity outperformance. We lowered our year-end MSCI EM index target to 1175, which equates to a calendar year decline of 5.2%, vs. our prior target of 1275, which implied a 2.4% gain for 2008.

However, from a longer-term perspective, recent selling has improved the risk/reward ratio of the EM equities, in our view. The asset class recently traded at a 2008 estimated P/E-to-growth (PEG) ratio of 0.77%, reflecting consensus expectations for a 15% increase in 2008 earnings and a 2008 estimated P/E of 11.5. In addition, despite our neutral short-term outlook, we believe long-term oriented investors should maintain exposure to this asset class, as we think the infrastructure and consumption-driven secular growth of developing economies remains intact.

The S&P global ETF asset allocations for moderate and growth-oriented investors dedicate 3% and 6%, respectively, to the EM equity asset class.

Emerging Asia

We believe the region's domestic economic outlook remains strong thanks to rising per-capita incomes, increasing consumption, and significant infrastructure investment. But after several years of solid outperformance, equities in emerging Asia have lagged those in most other international markets this year, and we expect the trend to persist through 2008.

With our view that Asian domestic economic momentum remains intact, we believe many of the challenges are external. One fear is that slowing growth in key export markets like the United States, Europe, and Japan will hurt revenues and earnings at emerging Asia multinationals, since the region's economies continue to be largely export-driven. While current 2008 earnings growth expectations remain in the low double-digit range, they have fallen substantially since January.

Emerging Europe

The performance of this asset class is down modestly in 2008, as positive Czech returns have been diluted by weakness in Polish, Hungarian, Turkish, and, to a lesser extent, Russian equity performance.

S&P believes the region's long-term fundamental outlook is relatively healthy. Despite slowing growth in the Eurozone, a key trading partner, Global Insight expects emerging Europe to post 2008 real GDP growth of 5.7%, with Russia, the region's largest economy, projected to grow 7%.

While the Russian economy is arguably too dependent on energy exports, we believe two factors mitigate this risk. First, rising incomes and credit growth have led to strong Russian household consumption, which is supporting service and manufacturing growth, and is helping to diversify the economy. Second, although increasing speculation has made a short-term correction in raw material prices likely, in our view, we believe a secular increase in emerging market demand, combined with tight global capacity, will keep the long-term commodity uptrend intact.

S&P expects emerging European equities to continue outperforming most other major global equity asset classes through year-end.

Latin America

Latin American equities are the best-performing, major equity asset class this year, and Brazil's performance has been especially strong, allowing it to surpass China and India to become the world's largest emerging equity market.

S&P Equity Research believes Latin America's strong year-to-date performance has been driven by a relatively benign macroeconomic environment, increasing consumption, strong earnings growth momentum, and low relative valuations. Global Insight estimates Latin American real GDP growth of 4.6% in 2008, with Brazil, the region's largest economy, forecast to post growth of 5.1%. Additionally, Mexico is weathering the U.S. slowdown relatively well, in our view, and is expected to post 2.9% real GDP growth in 2008.

Middle East & Africa

Middle Eastern & African equities have modestly outperformed other emerging markets year-to-date. In addition, the region's returns remain less correlated to other global equity markets than Latin American or Asian developing stock markets. S&P believes this is because globalization has yet to fully reach many of the region's countries.

With global equity correlation on the rise, money managers are increasingly attracted to this asset class as a way to increase their equity portfolio diversification, in our view.

Middle Eastern & African equities are also benefiting from strong economic growth, which is being supported by rising commodity prices, ample domestic liquidity, and significant government infrastructure spending.

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