Merrill Lynch: Emerging Markets in Grave Danger

Plunging commodity prices and soaring funding rates will keep investors away from emerging markets for a while, says Merrill Lynch

The third quarter was the worst in terms of performance for emerging markets. The MSCI Emerging Markets Index fell 28% in the July to September period mainly because commodity prices plunged and funding rates soared, according to Merrill Lynch, which adds that the markets remain in "maximum danger".

"A sustained cyclical bid is unlikely to return to the asset class until we see a reversal in some of the current macro, risk and positioning negatives. There is a much better case for a soft landing in emerging markets than in the G7," Merrill Lynch says in a report .But investors need a trough in global leading indicators, an easing in credit, FX and risk strains, and policy easing in emerging markets before they buy.

Even if any significant buying transpires, it will most likely take place in 2009.

There are those advocating that investors summon their confidence and buy into the severely battered stock markets. Merrill Lynch's analysts, led by New York-based global emerging markets equity strategist, Michael Hartnett, are not among those putting a positive spin on the markets.

It's not yet the time to buy because even though the trailing price-to-earnings ratio just fell to an all-time low, price-to-book is only a tad below historic average, Harnett's team says.

Merrill Lynch notes that recession risk is soaring and emerging market equities are still playing catch-up with collapsing growth expectation. Until these stabilise or recover a sustained rally is unlikely. The good news is policymakers are now squarely focused on downside risks to global growth and that means policy easing is on its way.

"There will be no bid for global equities, emerging and frontier included, until credit markets improve and funding rates drop," Harnett's team says. "Investors need to see policymakers stabilise the credit markets and improve risk appetite."

After receiving around $100 billion in inflows between 2002 and 2007, emerging markets have seen around $30 billion in redemptions in recent months, Merrill Lynch says. And when investors are forcibly pushed to exit directional positioning, they are usually reluctant to re-enter, the firm adds, hindering any upside for the market in the next three to six months.

Under these circumstances, Merrill Lynch recommends focusing on the "best of breed" and reflation themes looking ahead to 2009.

"Best of breed" was the best equity strategy in the 1992 to 1998 phase of the Japanese bear market, Merrill Lynch says, referring to sticking to stocks of companies that are among the leaders in their industries. The firm notes that Japanese blue-chips massively outperformed the broader Tokyo bear market of the 1990s despite the strong yen.

Meanwhile, Merrill Lynch expects a big inflection point for inflation in emerging markets. Its inflation model shows that for the first time since spring 2007, the majority of CPI releases in emerging markets are coming in below expectations. This opens the door to greater policy stimulus in emerging markets and the monetary and fiscal policy reflection theme in likely to gain traction in the fourth quarter of this year.

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