Have emerging markets underperformed in 2011?

15th December 2011

Although part of this has undoubtedly been a general aversion to risk assets, more important has been worries over hikes in interest rates. That interest rate cycle now appears to be drawing to a close with many emerging markets either keeping rates on hold, or reducing them in response to the crisis in the Eurozone, which may in turn give a boost to unloved emerging market equities.   

This Reuters piece suggests that emerging markets may be an area to watch in 2012 for this reason.

"Emerging market central banks are less concerned about inflation when the global economy looks weaker. In one sign of this shift, China's central bank cut reserve requirements for banks in November, easing credit for the first time in nearly three years. That helps China's economy, but also trading partners like Brazil. Also, whenever these countries lower interest rates, equities become more attractive investments."

The OECD also suggests interest rate cuts in China may be a possibility: "Growth in China is set to slow further, opening the door for interest-rate cuts by the middle of next year, the Organization for Economic Cooperation and Development said."

Among economists, interest rate cuts in China are by no means universally predicted, but the balance is with monetary easing: : "Eleven economists of 20 in a Bloomberg News survey conducted yesterday and today (last week) say rates will stay unchanged through next year and another four predict increases. Goldman and HSBC are among five that see cuts."

Much depends on the situation in the Eurozone: Capital Economics forecasts five more reductions in reserve ratios before the end of next year on the back of weakening economic data. The same article quotes Mark Williams, an economist at Capital Economics: "The speed at which the euro-zone crisis is escalating suggests external conditions will be more challenging over the next year than previously seemed likely. In turn, policymakers are likely to respond more forcefully."

Brazil is further down the line than other emerging markets, having already cut its base rate: "The bank said that a "moderate adjustment to the base rate" was needed in order "to mitigate at this moment the effects coming from a more restrictive global environment". Analysts said the latest move showed the bank was more concerned with stimulating the economy than with rising prices."

The Government's move was largely down to weakness in the economybut was controversial: "Brazil is the largest emerging-market economy so far to have begun easing. And, given the country's chequered history with inflation, which in past decades was a destabilising force in the economy, the issue is highly sensitive."

A number of other countries have also begun the tightening cycle: "Indonesia's central bank unexpectedly slashed its key lending rate by 50 basis points on Thursday as monetary policy easing by Asian central banks gathered pace in the face of slowing economic growth and the European sovereign debt crisis. Central banks in South Korea and Malaysia meet on Friday to discuss monetary policy, with currency markets signalling expectations that both will hold interest rates at their current level, or even announce a cut."

In the other major emerging market economies, Russian rates are on hold, while Indian policymakers still believe that inflation is the greater threat and are continuing to raise rates: "The Reserve Bank of India (RBI) raised its key rate to 8.5% from 8.25%, the 13th increase since March last year. The increase comes amid a high rate of inflation that saw consumer prices rise 9.72% in September from a year ago. The RBI also cut its growth forecast to 7.6% from 8%, citing worsening global economic conditions."

Of course, it might not last. Larry Kantor, global head of research at Barclays Capital, said: "[Monetary easing] is a reaction to the financial instability that we are seeing, mostly coming from the eurozone sovereign debt situation," "I think at some point in the future you are going to go back towards tightening because inflation is still a problem throughout the region."

In the meantime, if history is repeated, markets are likely to react positively to the shift in direction by emerging market policymakers. As such, 2012 may well be a stronger year for the asset class.

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