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The silver lining in the emerging markets rout

September 23, 2011: 11:14 AM ET

Emerging markets have been caught in the global contagion sparked by the European debt crisis. But these economies still have something most others don't: Growth in local demand for goods and services.

By Cyrus Sanati, contributor

FORTUNE -- The European economic contagion is threatening to become a worldwide flu as the financial turmoil spreads to the once high-flying emerging market economies. Stock indices from South Korea to Russia to Brazil plummeted on Thursday and continued their sell off on Friday amid fears that a global recession may be underway. The "risk off" trade has now enveloped nearly every asset class at this point, leaving just the U.S. dollar as the world's sole safe haven investment.

But the economic fundamentals may be on the side of the emerging markets, setting them up for a major relief rally once the panic has abated. Swift action is needed by the governments of these countries to make sure that their economies can survive this market rout and re-emerge as strong investment alternatives for Wall Street.

The emerging markets have been the darlings of Wall Street for the last two years as investors sought yield amid anemic growth rates in the U.S. Commodity-driven economies like Brazil and Russia as well as export-driven economies like China and South Korea have delivered double-digit percentage returns to equity and currency investors, outperforming established economies. Investment dollars flowed freely out of U.S. and European stock markets and pumped up those in Asia and Latin America, while currency traders took out short dollar positions, raising the value of emerging market currencies versus the greenback, especially in Brazil and Australia. So far this year, inflows into emerging market fixed income funds alone were $36 billion, according to JP Morgan (JPM).

But that may all be coming to an end. It was the emerging markets that took the brunt of the burn of the last few trading sessions, with the MSCI Emerging Markets Index losing 11% on the week, its biggest loss since 2008. Stocks in Korea closed overnight down 5.73% to 1,697, that market's lowest close in 15 months. It was the same story in the Philippines, which closed down 5.13%. And the Asian benchmark Hang Seng Index in Hong Kong closed the week down 9%, its worst weekly loss since October 2008. To make matters worse, most emerging market currencies have reversed their gains for the whole year against the U.S. dollar in just the last week.

Total emerging market equity funds have seen $1.4 billion in redemptions for the week ended September 21st, the latest data available from exchanges. There are no signs of the sell-off abating, with $183 million of outflows seen just in Korea on Friday.

The vast majority of this selling occurred following the Fed's announcement of its new "Operation Twist" plan Wednesday afternoon. The markets felt that the Fed action, which hopes to lower long-term interest rates, would not be as effective as another round of quantitative easing. Inflation fears caused investors to start pulling out of the emerging markets Thursday morning, which exacerbated the sell-offs around the globe.

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.

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