The Chinese financial markets began 2016 with a bang, testing the newly minted circuit breaks for the first time in a 7% slide. Meanwhile, the Bovespa (the Brazilian Index) has declined for three straight years in local currency and lost more than 60% of its value in USD. Even in India, a rare case of growth success for an emerging economy in 2015, the S&P BSE Sensex was down 5% at the end of 2015, while the Nifty50 closed 4% lower than December 31, 2014. In the last few days emerging stocks have rebounded and cut some of the losses, but not significantly. How much should the rest of the world worry about the signals given by the BRICs stock markets? The answer is: not much, if at all.
There is one assumption that is wrong when searching for signals from stock markets, at least in the context of emerging economies. They are not a good leading indicator of the relative strength of emerging economies. For developed economies, stock markets are a good leading indicator, whereas for emerging countries much less so. There are many reasons for that:
1 – Companies in emerging countries are not mature enough to serve as a good signal:
Blue chips are a fixture of stock markets in developed countries. They constantly generate profits, pay dividends, and are a good gauge of industrial activity. If they slash investments and dividends it means weak future industrial activity. Agents are thus able to truly diversify their portfolio between dividend-generating stocks and companies that generate value from growth. Value investors are rewarded for their patience, while growth investors may capture extra value from a sustainable increase in profits, with stocks generating signals about the strength of the whole economy. However, stock markets in the BRIC countries are relatively new and most companies are far from mature. Take the Brazilian case, for instance. Its two “blue chip” companies, Petrobras and Vale, have lost more than 80% of their value in the last 5 years. Examples like these abound – Gol, the second largest Brazilian carrier, have lost 85% of its market capitalization in 2015 alone, something that usually is reserved for companies on the verge of bankruptcy, or start-ups.
2 – Many sectors are not represented in emerging countries stock markets:
Chinese stock markets are dominated by financial services and heavy industry. Even in Indian stock markets, a relative success regarding its number of listed companies, the consumer durables industry is represented by less than 20 companies, many with low liquidity. The Bovespa is highly liquid in a small number of companies, with a worrying trend, namely more companies delisting than the arrival of new IPOs (less than five in the last three years). If Chinese growth is increasingly going to come from retail and services, then the stock market loses even more predictive power on the underlying strength of the whole economy, since precious few service providers are listed in China.
3 – SOEs and faux-SOEs are particularly relevant in emerging markets:
SOEs dominate in Brazil, China, Russia, and even South Africa. Some supposedly privatized companies are still haunted by government interference. For instance, the Brazilian government holds a golden-share, a de facto veto for a change in controlling interest in Embraer and Vale. A government’s say in the management of SOE’s pension funds had the Brazilian government influencing the ousting of the former CEO of Vale, Roger Agnelli. The lack of transparency and possible meddling means that stock prices do not reflect the true cash-flow generating capacity of many firms in emerging markets. Stock markets are thus much more opaque than in developed countries, revealing much less about the economy as a whole.
4 – Emerging countries stock markets are less liquid or present market failures:
Foreigners cannot own stocks in China. Brazil and India are more open, but less so than Russia. There are many “zombie” listed companies in Brazil, companies that are listed in the stock exchange but have little if any daily transactions. Even if some sectors are well represented in a BRICs’ stock market, the lack of many liquid stocks may prevent a researcher from gathering pertinent information about the industry.
5 –Volatility in emerging stock markets is much higher than in developed markets: Below is the volatility index (VIX) of stock markets and individual stocks, as measured on January 05, 2016.
|CBOE Volatility Index®||VIX||20.55|
|CBOE NASDAQ Volatility Index||VXN||22.82|
|CBOE S&P 100 Volatility Index||VXO||21.83|
|CBOE DJIA Volatility Index||VXD||19.76|
|CBOE Emerging Markets ETF Volatility Index||VXEEM||25.70|
|CBOE China ETF Volatility Index||VXFXI||31.97|
|CBOE Brazil ETF Volatility Index||VXEWZ||45.72|
|CBOE Equity VIX® on Amazon||VXAZN||44.92|
|CBOE Equity VIX® on Apple||VXAPL||36.89|
|CBOE Equity VIX® on Goldman Sachs||VXGS||31.12|
|CBOE Equity VIX® on Google||VXGOG||32.99|
|CBOE Equity VIX® on IBM||VXIBM||27.74|
Source: CBOE, 2016. https://www.cboe.com/micro/volatility/introduction.aspx
We can see that volatility of ETFs that track the Chinese and Brazilian markets are markedly higher than their US counterparts, and even higher than individual stocks in the US market. In the end, we cannot put too much faith in the informational content of swings in BRICs stock markets, unless it is corroborated by many other variables. Gauging the strength of the BRIC economies through stock markets is a dangerous gamble, and swings in stocks are not a good leading indicator of economic activity, at least till these countries, and their companies, mature.