The Emerging Thud

September 29, 2011

We use a number of methods to determine likely returns in various asset classes, but our favorite is to adapt GMO’s methodology of a seven year projection. This approach assumes everything is normal, average, unexceptional. It assumes that stocks will trade at approximately fair value.

So let’s start with the good news! With emerging markets in an out and out bear market overall, we now see Emerging markets as finally cheap. Returns should come in somewhere around 9% above inflation assuming growth is normal, inflation isn’t too high and they are not too far from fair value (with fair value meaning they should using the same approach deliver around 6% above inflation.)

However, they could get a lot cheaper, and two key sets of data give us reason to believe that is getting more likely.

The first we discussed last week, the stunning fall in industrial metals, which correlates highly with global manufacturing in general. See also here for copper’s divergence from US equity market performance.

Today Cullen Roche digs into the underlying Manufacturing Purchasing Managers Index’s of Brazil, Russia, India and China. Also known as the “BRIC” countries. The performance of these countries is a key to further global economic growth and US corporate earnings:

This is important because the countries have been the one truly strong leg in the global recovery.  This has been nowhere more apparent than in corporate earnings.  While domestic revenues have remained flat to down, international companies continue to experience strong growth on the back of this growth.  But the trend appears to be changing.

If we look at the most recent PMI from all four nations we can see how different this slow-down is from the scare in 2010.  It’s deeper in all regions (except China).  Brazil, Russia and China are already in contraction mode and in the case of Brazil it’s quite deep at 46.  India’s PMI readings are still on the expansion side, but at levels seen just 2 times in the last 6 years.

More from Cullen:

This is the primary exogenous risk to the US markets at this juncture.  If the BRIC countries were to experience a substantive and sustained recession, Europe and the USA would suffer mightily as they continue to struggle with their balance sheet recessions.  This is a story that needs greater attention as Europe and the USA steal the spotlight.  This is just one more piece in an already worrisome global economic puzzle.

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