September 19th, 2013 | By Nick SargenHighlights
From the beginning of 2000 to the end of the decade, emerging equity markets were among the best asset classes for global investors. The MSCI EM equity index, for example, generated an annualized return of 10%, while returns for developed markets were flat. With growth prospects for the emerging economies perceived to be much better than for developed economies, some observers contended the trend in outperformance would continue into the current decade.
In fact, the opposite happened. Developed equity markets have outperformed the emerging markets handily over the past 3 ½ years: The S&nbps;P 500 has generated a cumulative return of over 50% followed by a 17% return for EAFE, compared with only a 5% gain for the MSCI EM index. Even more telling, the ETF for the so-called BRIC economies consisting of Brazil, Russia, India and China has posted a cumulative negative return of more than 13% over this period. This underperformance occurred even though the emerging economies enjoyed reasonably strong growth compared with sluggish-flat growth for the developed economies.
For a while, investors shrugged off the disparity in performance on grounds that the outsized returns for the developed markets mainly reflected the impact of quantitative easing. As the performance gap widened during the first half of this year, however, the emerging economies have come under greater scrutiny from investors: The MSCI EM index fell by more than 9% and the BRIC ETF was off by 12% compared with a nearly 14% gain for the S&P 500 index. This development, in turn, has given rise to a re-appraisal of the long-term prospects for emerging equity markets.
A prominent example is a recent report from Goldman Sachs' economists entitled "Not your older brother's emerging markets," (June 19, 2013). Goldman's economists contend the stellar showing of EM assets in the previous decade is attributable to five macro tailwinds:
The main conclusion of the Goldman report is that none of the five major trends is likely to be repeated, and some may reverse: "Over the next decade, EM assets are unlikely to deliver the kind of risk-reward that investors had become used to in the last one. And absolute returns will likely be much lower."
My own assessment is that reversals of the first two factors – i.e. worries about China's economic slowdown and weak commodity prices – are the main reasons for the poor showing of EM equities. I am not in the camp that China is in an economic bubble, but it is too early to know whether the new long-term growth trajectory is the 7%-8% rate that the Chinese Government is targeting or a lower trajectory. Whichever outcome, I believe the commodity super-cycle is over, and the environment for commodity exporters will be less favorable.
That said, I am not bearish on EM equities, because policy reforms implemented in many countries in the past decade are still in effect. Accordingly, emerging economies as a group are not likely to experience massive budget deficits or external payments imbalances. Also, many of these countries have done a good job of reining in inflation and avoiding significant over-valuations of their currencies. In these respects, the situation confronting developing countries today is better than 1970-1999, when developing countries experienced numerous financial crises.
Given the magnitude of the underperformance, it's reasonable to ask whether emerging market equities represent a buying opportunity. Based on several recent research reports I've read, the conclusions are mixed.
Strategists at Societe Generale, for example, observe that the underperformance of the last 18 months means that EM and BRIC equities are no longer expensive in absolute and relative terms. (See "Bloody, Ridiculous Investment Concept (BRIC) Revisited," July 18, 2013.) However, they concede these markets could get even cheaper if China's slowdown becomes more pronounced.
BCA Research offers a more negative assessment in its July 3 report, "Will An EM Breakdown Transpire?": "BCA's Emerging Markets Strategy team maintains that there is more downside in EM risk assets, and that the odds of a breakdown in EM share prices is still considerable. Hence, we continue to recommend trading EM risk assets on the short side. Meanwhile, asset allocators should stay underweight EM assets versus their U.S. counterparts."
Finally, equity researchers at Credit Suisse offer yet another assessment in their report, "Preference for Europe over emerging markets." (August 8, 2013). They view continental Europe as more attractive on grounds that European equities are relatively cheap and there are signs the euro-zone is emerging from recession. By comparison, EM scores remain at the bottom of their macro scorecard.
Given these varied assessments, I find it hard to have conviction to add to EM equity exposure at this time. Valuations are not compelling enough given the uncertainty about the external environment. In this context, emerging economies could experience ongoing capital flight that puts downward pressure on the respective currencies and upward pressure on domestic interest rates. Moreover, it is too early to tell when the current vicious cycle will be completed.
While there is no clear consensus about the prospects for EM equities, the relevance of the BRIC concept increasingly is being called into question by investment strategists. The acronym was created in 2001 by Jim O'Neill, Goldman's Chief Economist, to describe the growing importance of Brazil, Russia, India and China in the global economy, and has been embraced in the media and by leaders of these countries. Based on the performance of their economies and markets over the past decade, it's easy to understand the popularity of the idea.
During the past three years, however, it is evident that the strategy of investing in these countries as a bloc is flawed, as their returns have been among the worst in the EM universe. The researchers at Societe Generale, in particular, have criticized the concept on grounds that there is "absolutely no correlation between EM investment returns and economic growth because investors overpay for growth stories and there is no margin for error." They point out that what really matters for investing is valuation, and investors typically pay too high a price for growth stories.
Beyond this, I contend that the BRIC concept is not useful as an investment theme, because the four economies are more heterogeneous than they are homogeneous. In my May 2011 whitepaper entitled "Is this the 'BRIC' Decade?" I pointed out that China's emergence as a global super-power is by far the most important story, as its economy is now greater than that of Brazil, Russia and India combined. Over the past decade, its share of the world economy nearly doubled to 14%, while the three other economies have held steady at about 3% each.
The four economies also face diverse challenges. The over-riding challenge for China is transitioning away from an export and investment-led model of development to one that is based on domestic consumption. For India, the ongoing challenge is to keep the reform process going, reduce bureaucratic red tape and improve productivity. For both Brazil and Russia it remains to be seen how well they will fare when confronted with an external environment that is less favorable to raw materials.
My conclusion then and now is the same: "There is no easy shortcut for investors who are considering these countries other than to do extensive research on the risks, as well as opportunities, each of them affords."