Will the performance of emerging market equities take flight? Or will it be grounded—at least for the short term?

Today’s global environment is uncertain, and although valuations are not demanding, emerging markets face headwinds in the short term. The secular drivers of emerging markets remain in place for the longer term. However, in the short term, the rise of economic nationalism and growing questions on the benefits of globalization may depress sentiment.

The emerging market asset class has had a run of strong performance for the seven-year period ending July 31, 2008. The Morgan Stanley Capital International Emerging Markets Index (MSCI EM) returned 12.4% per annum in Canadian dollars—handily outperforming the MSCI Canada Index, which returned 8.5% over the same period. But over the next six months, and possibly longer, emerging markets will face an increasingly difficult global environment.

One year after the current credit crisis began, the situation in the global credit markets has yet to stabilize. The U.S. Treasury’s dramatic and explicit support for Fannie Mae and Freddie Mac in September, the recent performance of many major bank stocks and the elevated Treasury-Eurodollar spread are all evidence of ongoing strains in global markets.

As of late August 2008, global financial institutions had written off roughly US$500 billion in mortgage-related loans and securities. In April 2008, the International Monetary Fund estimated that potential losses would total approximately $1 trillion, and some analysts place the number even higher. Participants at a recent conference in Jackson Hole, Wyo., sponsored by the Federal Reserve, emphasized the ongoing need to recapitalize many U.S. financial institutions. Furthermore, there is growing evidence that U.S. lending standards are tightening— an additional factor inhibiting U.S. growth.

In the short term, emerging market economies face challenges that include the growing possibility of a U.S. recession brought on by continuing declines in many residential housing markets and a potential decline in both personal consumption and investment; slowing global growth and the increasing possibility of a global recession in 2009; high oil and food prices relative to 18 months ago; rising headline inflation in both the developed and emerging world; and more rigorous global lending standards and more expensive credit.

U.S. Stresses

One notable aspect of the current situation is that despite the unfolding of a financial crisis—which has been described as the most severe financial crisis since the Second World War—the real economy in the U.S. has proven to be remarkably resilient. Technically speaking, the U.S. still has not fallen into a recession, although unemployment expectations exceed 6.3%. Strong export growth facilitated by a weak dollar, along with monetary and fiscal policies to stimulate the economy, has helped to offset conditions in the credit markets.

Milton Friedman famously remarked that monetary policy works with “long and variable” lags. There is no particular reason to expect that the U.S. economy will not respond to monetary stimulus in this cycle as it has done in previous slowdowns, but trend growth is unlikely to resume until next spring at the earliest. Continued strains in the U.S. Auction Rate Preferred Market, as well as various asset-backed and mortgage-backed markets, suggest that risks to the real economy are to the downside.

Join us on Twitter