Emerging Stocks Priced for Profit Tumble Signal Bottom to Morgan Stanley

The lowest developing-nation equity valuations since January 2009 are a sign that the MSCI Emerging Markets Index’s worst tumble in three years is nearing an end, according to strategists at three of the world’s biggest banks.

Concern that global economic growth is faltering sent the measure down 15 percent this month through yesterday, to 8.9 times estimated profits, 30 percent below the 20-year average, data compiled by Bloomberg and Morgan Stanley show. Valuations imply emerging-market earnings will drop about 20 percent in the next 12 months, according to the New York-based bank.

The retreat may be overdone because rising consumer demand in developing nations will boost profits by 3 percent even if advanced economies slip toward recession, Europe’s debt crisis worsens and China keeps a tight monetary policy, said Jonathan Garner, Morgan Stanley’s chief Asia and emerging-markets strategist. Shares may hit bottom within days, said Jason Press at Citigroup Inc. Valuations are at levels seen two years ago after Lehman Brothers Holdings Inc.’s collapse and in the 1990s emerging-market crises, said Nicholas Smithie at UBS AG.

“Stocks look like buys,” Smithie, the New York-based emerging-market strategist at UBS, Switzerland’s biggest lender, said in an Aug. 8 telephone interview. “There has to be a Lehman-style collapse in economic activity and stress in the financial system for these valuations to be justified.”
$7 Trillion

Investors who purchased shares when the MSCI emerging index fell below 9 times earnings in October 2008 were rewarded with a 60 percent rally during the next 12 months, according to data compiled by Bloomberg. The gauge jumped 44 percent in the year after valuations tumbled that low in August 1998, the month Russia defaulted on $40 billion of debt, the data show.

The index climbed 2.4 percent to 991.84 as of 6:54 a.m. London time. The gauge’s drop in the past six days was the biggest since October 2008, a month after Lehman’s bankruptcy roiled world markets and helped spark a global recession. The unprecedented downgrade of America’s top credit rating by Standard & Poor’s, weaker-than-estimated U.S. economic data and signs that Italy and Spain may struggle to refinance debt have eroded investor confidence in riskier assets this month, erasing almost $7 trillion of stock-market value.

Samsung Electronics Co., the world’s second-largest maker of mobile phones, and OAO Gazprom, Russia’s natural-gas export monopoly, led declines in emerging markets as benchmark equity indexes in Brazil, Russia, India and China fell more than 20 percent from recent highs. MSCI’s emerging-market gauge pared declines yesterday after the Federal Reserve pledged to keep its benchmark interest rate at a record low at least through mid-2013 and closed down 2.2 percent.
Record Profits

There are no signs yet of a collapse in emerging-market earnings. Second-quarter profits at MSCI index companies jumped by an average 30 percent, more than five times the MSCI World (MXWO) Index’s 5.6 percent gain, data compiled by Bloomberg show.

Twelve-month earnings per share in the emerging index climbed to a record high of $95 last month and may increase 19 percent in the next 12 months, according to the average of more than 12,000 analyst estimates compiled by Bloomberg. Garner at Morgan Stanley, the sixth-largest U.S. bank, said his “base case” estimate is for earnings growth of 13 percent.

Developing economies will probably expand 6.4 percent next year, compared with 2.6 percent in advanced nations, according to June estimates from the International Monetary Fund.

Stocks are “pricing in an earnings recession, which certainly does not seem to be the case,” Press, a New York- based emerging-market strategist at Citigroup, the third-biggest U.S. bank, said in an Aug. 8 phone interview. “The market panic has gone too far.”
Higher Rates

While analysts are projecting higher profits during the next 12 months, they trimmed forecasts by about 3.8 percent since mid-July, according to data compiled by Bloomberg. Estimates are likely to drop further as weaker global growth erodes companies’ earnings prospects and central banks in some developing countries tighten monetary policy, said Adrian Mowat, the chief Asia and emerging-market strategist at JPMorgan Chase & Co. in Hong Kong.

Brazil and India raised interest rates five times this year to curb inflation, while China lifted borrowing costs three times. A Chinese government report yesterday showed inflation in the world’s second-largest economy accelerated to 6.5 percent in July, the fastest pace in three years.

“I don’t think the buy point for these markets is now,” Mowat said in an Aug. 8 phone interview. “What signals the end of this tightening cycle is weaker economic data followed by lower inflation. That is probably an event that is some point in the fourth quarter.”
Reversing Forecasts

Falling commodities have already eased inflation pressures in emerging markets, spurring traders to abandon expectations for further rate increases. The S&P GSCI Spot Index of 24 commodities dropped 18 percent from this year’s high on April 8.

China’s inflation rate may have peaked in July, Jim O’Neill, chairman of Goldman Sachs Asset Management in London, said in an interview on Bloomberg Television yesterday.

Yields on Brazil’s interest-rate futures indicate that policy makers will cut the benchmark interest rate from 12.5 percent by December, according to data compiled by Bloomberg. As recently as July 15, futures showed the central bank would raise borrowing costs this month. Traders in India also are tearing up predictions for an interest-rate increase as soon as next month as the government says lower commodities may cut inflation.
‘Outstanding Value’

Concern about “inflation and policy tightening in Asia and emerging markets is clearly ending,” Morgan Stanley’s Garner said in an Aug. 8 phone interview. “In our base case, there would be outstanding value in the market here.”

The Hong Kong-based strategist’s “scenario-weighted” 2011 target for the MSCI index is 1,305, or 35 percent higher than yesterday’s level. Garner’s “bear case” estimate for the gauge is 940. Investors should favor shares of companies that sell to domestic customers and hold “overweight” positions in China, Russia, Brazil and South Korea, he said.

For billionaire investor Wilbur Ross, the selloff has created long-term buying opportunities in emerging markets even if prices don’t bottom in the next few days.

“We’ve been pecking away at things as they decline,” Ross, chairman and chief executive officer of WL Ross & Co., said in an Aug. 9 interview on Bloomberg Television. There’s “plenty that’s attractive in the emerging markets,” he said.