All markets have disappointed of late, but that's especially true in the case of 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 proven vulnerable 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, they deserve 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 approximately 20% a year during this long stretch. Meanwhile, Russia's MICEX stock index rose approximately 24% per year, India's Sensex index 19% annually, and China's Shanghai index by approximately 3% a year.
Against such a brilliant backdrop, it is easy to understand the sudden loss of enthusiasm brought by underperformance during the last 12 months. (It should be noted that other emerging markets, less popular since the BRIC concept needlessly narrowed investor focus, have done better.)
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, which has risen to levels comparable to developed markets. This has elicited concerns over future pricing and market gains. The other has to do with economic fundamentals, especially the inflation that has begun to plague these economies, and their likely adverse effect on growth.
There is no question that these economies face serious challenges. And inflation indeed 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. These governments have responded with monetary restraints of various kinds that, though an appropriate response, threaten growth prospects. The mere appearance of such problems has shaken a former, firm confidence that these economies could avoid such infirmities.
Certainly, policy makers in these economies have sought to restrain growth. China, India and Brazil have all raised interest rates (with India warning of more increases to come).
Though all this restraint has slowed the pace of growth, investors need to consider that these economies still anticipate growth rates in excess of those in the developed economies. China, with all its recent restraint, still recorded a 9.5% annual rate of real growth in the most recent report on its 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, both in the 4% to 4.5% range. These prospects outpace the growth anticipated for Japan and the developed West and by a wide margin.
Long-term investors also should not lose sight of the fundamental development opportunities remaining in these economies and the impressive growth they will tend to bring as they are exploited.
These opportunities vary greatly from one economy to the other, but one example comes 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, but the effect far outstripped expectations, as the improved rail links, airports, and roads 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 they could from 2000 to 2010, they can nonetheless sustain an impressive upward trend. Granted, higher valuations raise questions about how much equity prices will reflect that growth, but this worry 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. 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 individually to continue to post strong performances, and certainly better than most developed markets over the long haul.
Milton Ezrati is senior economic strategist at Lord Abbett and an affiliate of the Center of Economic Growth in the Department of Economics as the State University of New York in Buffalo.
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