The Sky Is Falling

October was a bad month for equity brokers in most emerging markets. Irate customers must have been calling constantly, selling stocks and using not nice words. Argentina, Brazil and Peru in Latin America; India, Indonesia, Korea and Thailand in Asia; Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Lithuania, Poland, Romania, Russia, Turkey and Ukraine in Eastern Europe; Egypt in the Middle East all lost about 30% of market value. In one month. Other countries would have fallen similarly -- say Pakistan -- except they introduced price floors.

I spoke to several brokers to understand what is happening. Some countries are easier to figure out -- e.g., Hungary, Romania and Ukraine; it is not that obvious why other countries fell as much. Supposedly one of the reasons to invest in emerging markets is that returns there are less correlated with returns in the United States and other rich countries.

The explanation, in short, is two-fold: low liquidity and panic. Many emerging markets have quite low liquidity. So when a few sellers show up at once, they magnify the effect of trading. Low liquidity is good in good times -- you see big upward swings; but is frustrating in bad times. As times have been good this decade, it is only now that the downsides are apparent. The second explanation, panic, is a global story. It, too, is amplified in emerging markets, as retail investors there are relatively recent, and thus unschooled in "you-are-in-it-for-the-long-run" mantra.

A story often written in international media is that foreign portfolio investors may pull out money from emerging markets to cover weakened positions in home markets. This so far has not been much the case. It may become a story in December when investors need to close the books on the year.

What about 2009? By then, the global recession will start hitting emerging markets through reduced exports, slower direct investment, and perhaps slower tourism and remittances. There is still great uncertainty who and how much will be hit. So investors will be wary to jump in until the dust settles.

As they wait, it is best to recall that markets over-react, and so do analysts. UBS, for example, has just released GDP growth projections for eastern Europe (see figure) that look scary. It's probably not going to be as bad.