Part of the reason for this is that price to earnings multiples in emerging market equities tend to fall when their central banks start fighting inflation. This is particularly important in Asia. U.S. dollars are moving out of Asian economies on fears that businesses might cancel expansion plans as the world faces another recession. External demand for Asian goods continues to weaken from their post-recovery peak in January of this year and there is concern that the local market is not developed enough to pick up the slack from reduced consumption from the west.
Consumption will soften the blow
While emerging markets will experience headwinds in a global economic slowdown, it doesn't have to be catastrophic as was the case in past downturns. While most emerging economies are clearly export driven, there are signs that the local economies could blunt the downturn by consuming more. The key would be for emerging market governments to protect the savings of their populace by supporting the local currency. For now, consumption rates in Asian countries are holding. Take a look at Korea. Recent weakness in exports and the sharp decline in the Korean stock market have yet to dampen domestic demand, with discretionary spending on imported cars remaining strong, for example, according to Barclays (BCS).
Asian governments can help support their local economies and pump up confidence in their markets to help stem the outflow of U.S. dollars, while at the same time supporting their local currency to preserve domestic consumption of both local and imported goods. South Korea appears to be on the vanguard of the emerging market economies in this regard. The Bank of Korea has been very aggressive this week in trying to stem slides in the won, dumping a reported $10 billion to make up for the investment outflows from Wall Street. The action was successful in capping losses on the won versus the U.S. dollar on Friday.
Such quick and decisive action on the part of the South Koreans should be replicated across other emerging market economies. This should be relatively easy for most of them as they possess large U.S. dollar reserves given their large trade surpluses with the U.S. The key will be to inject just enough dollars to preserve purchasing power without compromising the earnings power of their largest companies. A careful balance needs to be found, which will be bespoke for each country.
Emerging market economies are still slated to see robust growth next year despite the current headwinds. A larger percentage of that growth will be from a pickup in domestic demand as their populations grow richer. Cheaper commodity prices due to a perceived downswing in worldwide demand will help local businesses cut costs, allowing them to offer more of their products to the local population.
If local currencies remain stable, then purchasing power will be preserved, allowing for domestic consumption to grow despite the economic downturn. This silver lining should help emerging markets rebound from their current lows and once again become an attractive place for Wall Street to park its cash.
