With the global financial system expected to remain under stress for much of 2009, there is little consensus for clients who are looking to invest in emerging markets.

Some money managers believe that clients who invest in non-Asian emerging markets should adopt a defensive stance in their asset allocation to preserve capital, while others recommend realigning asset mixes to benefit from the growth of equities in the event of a market recovery.

Erik Nilsson, a senior economist withBank of Nova Scotia’s international research group in Toronto, says it all depends on whether “you’re an optimist or a pessimist.”

Non-Asian emerging markets are expected to continue to grow, albeit at an average pace that’s only about half of last year’s. But the slowdown is compounded by the fallout from the global credit crisis, which has turned out to be far more severe than originally believed — with expectations of more bad news to come.

“A lot of nasty surprises lie ahead,” says Mark Grammer, vice president of investments with Mackenzie Financial Corp. in Toronto and lead manager of Mackenzie Universal Global Future Fund. That said, he expects all the bad news to come to an end by mid-year.

The downbeat sentiment is echoed by various banks and investment houses. Britain-based Barclays Bank PLC, for instance, says in its 2009 outlook, issued this past December, that the first quarter “is set to be considerably worse than anything in the current cycle thus far.”

Leading institutions, such as the International Monetary Fund and the International Institute of Finance, have caused alarm bells to ring even louder by making downward revisions to their 2009 forecasts in the fourth quarter of 2008.

None of this is good for emerging markets’ equities. “When the world is off-kilter, investors revert to risk aversion and stay with safe assets,” says Charles Bastyr, a portfolio manager with Toronto-based Meadowbank Asset Management Inc. As a result: “Non-Asian emerging markets will be orphaned until confidence returns to the developed markets.”

Non-Asian emerging markets have been sold off more than their developed counterparts on the back of substantial deleveraging by institutional investors — especially hedge funds, Grammer says.

In addition, flows from banks in mature economies to emerging economies, as well as portfolio equity and debt flows to emerging markets, have fallen sharply, reflecting a pronounced adjustment of investors’ earnings expectations, according to the IIF.

The drying up of interbank flows and foreign currency funding pressures have caused corporate spreads in emerging markets to reach near-distressed levels, reflecting increasing default risk that is largely due to refinancing constraints. This past December, Ecuador defaulted on its debt (see story on page 32), and other countries in Latin America could follow suit.

That said, the IIF said in December: “Anecdotal evidence seems to suggest that foreign currency funding pressure in emerging markets has eased somewhat from the stress level in October, even if tension persists and funding costs remain elevated.”

Countries in the Middle East, Latin America and Africa that are net exporters of oil, iron ore and/or soft commodities such as food have been hurt by the price declines that have come with the global slowdown. However, Nilsson says, Eastern Europe is a beneficiary of lower commodities prices because it is a net importer of commodities.

Eastern Europe needs all the help it can get, as it is currently the least favoured region. Chuk Wong, vice president and portfolio manager with Goodman & Co. Investment Counsel Ltd. in Toronto, describes Eastern Europe as the “next Asian crisis waiting to happen.”

He says that an economic contraction in developed Europe — upon which Eastern Europe is dependent for exports — and a substantial “mismatch of foreign currency debt” will hurt the eastern region.

Another factor is exchange rates. Non-Asian emerging market’s currencies have depreciated significantly against the U.S. dollar since mid-2008, losing about a third of their value and making repayment of US$-denominated debt by both governments and corporations very expensive.

Some managers of emerging-markets funds believe the US$ will weaken by mid-2009. Mark Mobius, the Singapore-based manager of Templeton Emerging Markets Fund, which is sponsored by Toronto-based Franklin Templeton Investments Inc., is among them, although he also expects significant currency volatility during the year. But others say that if this volatility happens, it will be — as Nilsson puts it — “relatively short-lived.” IE