All markets have disappointed of late, but especially the emerging markets. Even aside from the recent global sell-off, they have handed once enthusiastic investors sub-par performance for more than a year now. Moreover, these economies have displayed a vulnerability to the ills— especially inflation—that investors had thought they were immune to. Some commentators and strategists point to such signs and declare an end to emerging markets as preferred investments. They recommend that investors rethink their allocations. Such warnings, though understandable, almost certainly go too far. No doubt emerging markets in coming years will fall short of their tremendous gains of the past 10 to 20 years, but ample reason remains to expect better performance there than in developed markets and, consequently, a place in investor portfolios.
Emerging market equities certainly had given investors a great ride for a long time. During the 10-year stretch to the close of 2010, these investments as a group returned almost 18% a year, according to the MSCI Index. That's a 17.5 percentage point annual premium over the S&P 500.
The difference was similar against European and Japanese indices as well. And that enviable performance was pretty widespread among emerging markets. Of the popular BRIC economies—Brazil, Russia, India, and China—Brazil's IBOV stock index rose at approximately a 20% annual pace during this long stretch, Russia's MICEX stock index rose at approximately a 24% annual pace, India's Sensex index at above a 19% pace, and China's Shanghai index by approximately 3% a year.
Against such a brilliant background, it is easy to understand the sudden loss of enthusiasm brought by underperformance during the last 12 months, especially in the popular BRIC markets. America's S&P 500 Stock Price Index, uneven as its performance has been, has beaten three of these four. In comparison to the S&P 500's 11% gain during this time, Brazil's Bovespa Stock Index fell 15% and India's index fell 6.5%. China's market showed no net movement. Only Russian stocks have outperformed America's, rising about 9% during this 12-month span.
Other emerging markets, less popular since the BRIC concept needlessly narrowed investor focuses, have done better. The 17% to 19% gain recorded for the MSCI Emerging Markets Stock Index during the past 12 months occurred despite the significant drag exerted by the heavy weight of the BRICs in the aggregate. Clearly, other less favored smaller markets outperformed significantly.
Of course, even during the salad days of the 2000-2010 decade, these markets registered occasional shortfalls. They have always been more volatile and have at times suffered dramatic setbacks. But this more recent setback looks different from this past and has troubled investors because of two additional considerations. One is valuation. These at last have risen to levels comparable to developed markets. In doing so, they have elicited concerns over future pricing and market gains. The other has to do with economic fundamentals, most especially the inflationary pressures that have begun to plague these economies and their likely adverse effect on growth.
The valuation issue reflects directly back on the great gains of the past. Most analysts recognize that more than half the remarkable emerging market equity returns of the last 10 to 20 years occurred because valuations could ratchet up from initially very low levels, first as surface fears of the unknown dissipated, then as these economies proved themselves more reliable, and finally, as their policies proved themselves more responsible. Some calculate that as much as three quarters of emerging market gains during this 10-year stretch occurred because of this valuation shift. Now that many emerging market valuations equal those of developed markets, investors legitimately conclude that this source of gain has likely played itself out.
Especially in light of the valuation question, concerns about recent inflationary pressures and other economic problems weigh that much heavier than they might. There certainly is no question that these economies face serious challenges. Inflation stands front and center. China's inflation at last measure shows an annualized rate of more than 6%. India's has come in closer to 9%, and Brazil's has broken a 6% annualized rate. The governments in these economies have responded with monetary restraints of various kinds that, though an appropriate response, threaten growth prospects. More, the appearance of such problems has shaken a former, firm confidence that these economies could avoid such infirmities.
Certainly, policymakers in these economies have sought to restrain growth. The People's Bank of China has over the past year increased its benchmark interest rate five times by over 125 basis points to 6.56%. It also has steadily removed liquidity from its financial system by raising the reserves Chinese banks must hold against deposits. In six moves, the People's Bank has brought this ratio up to a remarkable 21.5%. At least as aggressive in its own setting, the Reserve Bank of India shocked markets recently by raising its benchmark lending rate 50 basis points to 7.25%. Adding to the pressure, it warned markets of more to come. Brazil has raised its Selic benchmark rate five times so far this year to 12.5% at present. With the central bank promising more, consensus opinion now conservatively expects a 12.75% rate by year end and possibly higher. Russia, which has less of an inflation problem and so presumably has less need for restraint, is facing it anyway, not from policy but from capital outflows that approach an $80 billion annual rate, enough to more than offset any inflows from increased oil revenues.
But though all this restraint has slowed the pace of growth, investors need to consider that even so, these economies still anticipate growth rates far in excess of those in the developed economies. After all, China, with all its recent restraint, still recorded a 9 1/2% annual rate of real growth in the most recent report on its gross domestic product (GDP). India, for all the discussion of trimming its growth outlook, still carries a consensus expectation for the year ahead in excess of 8%. Russia and Brazil have less impressive growth expectations, 4% to 4 1/2% for the former and about 4% for the latter. But even these prospects outpace the growth anticipated for Japan and the developed West and by a wide margin.
Neither should long-term investors lose sight of the fundamental development opportunities remaining in these economies and the impressive growth they will tend to bring as they are exploited. Obviously, these opportunities vary greatly from one economy to the other. However, a general illustration of their power emerges from China's response to its own 2008 stimulus plan. Beijing's aim, when it implemented that massive 4 trillion yuan program, was to substitute infrastructure jobs for those lost to the recession in exports. It was described as a temporary, emergency measure. The effect, however, far outstripped expectations, as the improved rail links, airports, or just putting macadam down on roads that had previously been gravel opened tremendous commercial opportunities in areas of the country that had otherwise been isolated. So successful was the effort, in fact, that by 2009, while the global economy remained in recession, chronically optimistic Beijing had to revise up its growth estimates.
Such fundamental growth opportunities exist in all these economies. Though they no longer have the power to drive growth as fast as during the 2000-2010 period, they can nonetheless sustain an impressive upward trend. Of course, the higher valuations in these markets raise questions about how much equity prices will reflect that growth, but this worry, too runs the risk of exaggeration. If valuations cannot repeat the huge re-rating of the past 10 to 20 years, they are, nonetheless, far from stretched. The Chinese market, for instance, carries price/earnings multiples presently of well under 14 times historic earnings, about equal to the comparable figure in the American market. If such comparisons argue against a sudden upward re-rating of China's market, there is certainly no reason to expect collapse. After all, the American market, the point of comparison, is hardly pricey, as its multiples now sit below their long-term averages. Neither is China likely to relapse into the economic and policy mismanagement that once won it especially low valuations. The same calculations, with minor differences, apply to most other emerging market as well.
Though it would certainly be a mistake to look for emerging markets to duplicate their past performances, circumstances should still permit these markets as a group, if not each and every one of them, to continue to post strong performances, certainly better than most developed markets, not each and every year or quarter, of course, but over the long haul.
Milton Ezrati is the senior economic strategist
at Lord Abbett and affiliate of the Center on
Economic Growth in the Department of Economics
at The State University of New York at Buffalo.
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