The Break-Up Of Emerging Markets In Full Swing

It's post-boom time for the emerging markets.  Depending on who you ask, emerging markets are caught between "crisis-mode" and "slower growth".  If Brazil, for example, can grow faster than the United States, it might just be seen as a miracle these days. Emerging markets are  not what they were once cracked up to be. And the recent noise over Fed tapering out of quantitative easing mode is making matters worse for what was once the greatest growth story on the planet.

"For years we've watched the emerging markets be an index buyers market or a country buyers market," said Charles Stucke, chief investment officer of Guggenheim Investment Advisors. "Today, we think there is real opportunity for stock picking in emerging. This is no longer a place to be passive. You have to be very active. And even then it is going to be a bumpy ride."

This week The Economist is running an online debate with Morgan Stanley economist and author of "Breakout Nations" Ruchir Sharma saying the growth story is winding down and National University of Singapore professor Kishore Mahbubani saying oh no it isn't. In an online poll at the magazine, 59% say the period of fast growth in emerging markets is now behind us.

Although the worst may be over for the asset class, many fund managers  now believe that differentiation is set to drive returns in emerging markets. That doesn't mean investors are going to be choosing between the iShares MSCI Brazil (EWZ) exchange traded fund and the iShares MSCI Mexico (EWW) ETF.  It's time to kick the tires on the ground in these markets and look at the stocks of individual companies compared to their competitors in the same, or similar markets.

It's bottoms-up time in emerging.

"There's a lot of differentiation between the players than you've ever had before," said Joel Wells, a fund manager at Alpine in Purchase, NY. He compares the different Brazilian real estate developers for instance.  Take São Paulo based $1.5 billion home builder EZTEC, beating the market year-to-date and up 3.11% with a 2.05% yield. Gafisa on the other hand, the only ADR in the Brazilian homebuilder space, has seen its market cap collapse to less than half a billion today. That stock is down 50.5% and has no yield.

Emerging markets are suffering for different reasons. Policy missteps in Brazil and India. Weak exports and lackluster domestic demand in China.  That's one side of the coin. The other side is the Federal Reserve and the upcoming questions over tapering.

Markets hate uncertainty. Risk markets like emerging hate it more. As a result, investors are starting to look at these markets differently. These aren't uniform boom towns anymore.

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"We have uncertainty around Fed tapering, even though we have a sense of what it is going to do. And we have the uncertainty about the emerging market growth model," said Wells. "Investors can no longer just look at the macro or make decisions on a top down basis. You have to be bottom up and that is a lot harder for us.  We think that once we get through this period of volatility, that differentiation will pay off."

Barclays Capital analyst Jose Wynn said in a note to clients on Tuesday that while now is not the time to be caught holding emerging markets, these developing economies are clearly breaking up into four distinct classes.

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There's no acronym for the break up of the emerging markets. But here is where Wynn thinks some emerging market nations are diverging, from the best to the so-so.  Wynn views emerging through a fixed income lens. (Ranking definitions are my own.)

1. First Class. These are markets where credit and rates have held up during the recent sell-off in Treasury bonds. Israel, Poland, Czech Republic, Chile, and Korea are in this category.

2. Second Class. This group is characterized by stable credit and stable sell-offs in rates and currencies. Mexico and Colombia fit this description.  Central banks in the mature EM group have shown better inflation records. Barclays'  forex models suggest their currencies are close to fair value.