Emerging market equities haven’t done well this past month, but even with U.S. stocks being potentially overbought, emerging market assets are a risky proposition as countries face serious structural changes and expect slower growth.

equity risk premium

“We remain cautious on EM assets,” Societe Generale analyst Alain Bokobza wrote in a recent note. “Despite their recent underperformance relative to U.S. equities, emerging market equities remain vulnerable to further de-rating as the structural growth profile of some of these countries is undergoing significant transformation.” Outflows have only recently started and still don’t fully account for the structural changes occurring in emerging markets, causing the risk premium to be higher than it ought to.

In emerging markets, India and Brazil are even more vulnerable than China

While China has gotten the most press as investors wonder loudly if it will hit a hard landing, the Societe Generale report identifies India and Brazil as the economies most vulnerable to long-term growth deceleration. The equity risk premium offered by Indian equities (about 6 percent) is below the long-term average and falling. Brazil’s equity risk premium is actually higher than its long-term average (2.9 percent versus 2.5 percent) which only means that it has more to lose.

SocGen notes:

Equity risk premium (currently at 6%) offered by Indian equities has already fallen below its long-term average (6.6%). Further deterioration in long-term growth outlook will be negative for Indian equities. While Brazil’s current equity risk premium (2.9%) is above its long-term average (2.5%), even a 1% fall in long-term growth will bring its equity risk premium below the long-term average.

“While EM equities are now trading at a bigger discount (P/B) relative to the global equity market than at any time in the last five years, we believe EM equities may de-rate further,” writes Bokobza. “Unlike developed market central banks, some EM central banks (e.g. Brazil, India) are tightening liquidity to fight high inflation and currency weakness. These measures will weigh on economic growth in these countries.”

em outflows em equities risk

Emerging markets failing mainly due to local, not global, conditions

Emerging markets haven’t faced significant outflows for nearly a decade, but the reallocation of funds from developing to developed markets changed that this March. Fed tapering could actually accelerate this process later in the year, especially if the policy continues to drive public sentiment in favor of US stocks. As the Fed gradually increases interest rates, developing nations will have a harder time financing their debt (or at least will have to pay more for the privilege) further eroding the potential for growth.

Ultimately, the reason for emerging market devaluation has less to do with the U.S. rally and more to do with local conditions, which means there is no reason to expect it to stabilize soon.

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