Are emerging markets the next bear market casualty?

The theory that emerging markets could decouple from U.S. financial turmoil has officially been culled. The index is now in the midst of its worst draw-down since 2002 with major constituent index weightings in Korea, Russia, Taiwan, China and Brazil in a freefall.

Emerging markets have not escaped the global financial turmoil paralyzing stock and debt markets over the last 13 months. With commodities prices correcting sharply since July combined with record net portfolio outflows recently, the sector is now suffering its worst calendar year decline since 2002.

In 2008, the MSCI Emerging Markets Index has plunged 28% -- worse than the 20% decline logged by its sister index for the industrialized economies, the MSCI World Index.

Over the last sixty days two key markets in the MSCI Emerging Markets Index have been pummeled. South Korea (13%) and Russia (10%) are worth a combined 23% of the index and have added to the sectors’ woes this year as sharply declining currencies and stock indices encourage a massive exodus of portfolio flows. The biggest emerging market by stock market value is Brazil worth 16.7% of the benchmark.

South Korea has won the booby prize for the worst performing currency in Asia this year, down 19.4% versus the resurgent dollar. Last week the South Korean won sank to its lowest levels against the dollar in four years despite government intervention to support the currency. Korean shares have tanked 26% this year.
Soaring short-term debt levels, rising inflation, high consumer indebtedness and a run on the currency have evoked a return to the dark years of 1997-1998 when the entire region was engulfed amid credit destruction and asset price deflation. Korea is now entering a period of stagflation, similar to the United States, Japan and Western Europe.

In Russia, global investors have dumped stocks in Moscow en masse over the last thirty days following its invasion of Georgia. The Moscow RTS Index, loaded with natural resource stocks, mainly energy giants, has crashed 36% in 2008. The ruble, though weakening against major currencies remains loaded with a war chest of more than $500 billion dollars of foreign-exchange reserves and a healthy trade surplus, mainly due to high oil prices this decade. Yet Putin’s war on publicly traded companies has also hurt sentiment following another attack on a mining concern traded in Moscow last month.

Other emerging markets are also declining sharply in 2008. Chinese stocks have crashed almost 60% this year followed by a 44% loss in India. The BRICs, or popular emerging market countries, that include Brazil, Russia, India and China, has collapsed 33% in 2008.

But do the emerging markets deserve this sort of valuation?

Emerging markets continue to sport far superior economic fundamentals than the major markets. Banks in the sector don’t have questionable balance sheets like those in the West, have loads of free cash and will probably continue acquiring distressed American and European financial assets. For the most part, emerging markets in Asia, including Russia, have already been through a major economic crisis ten years ago.

Boosted greatly by a bull market in raw materials since 2002, these countries are still home to almost $3 trillion dollars’ worth of reserves and high savings rates. If oil and food prices continue to decline this fall then a strong case can be made for buying this asset class again. Lower inflation and stable interest rates would be bullish. But before this can happen, U.S. asset markets must stabilize.