Investors have regularly fallen in and out of love with emerging market investments. The reason isn’t hard to find. Emerging market equities substantially outperformed the U.S. over the past 10 years, but all of that extra return came during the first years of the decade. Despite weathering the global financial crisis better economically than the U.S., emerging equity markets have underperformed. The past year has been especially discouraging with an index loss of 6.84 percent while the down-home S&P 500 returned over 9 percent.
Do these rather dismal results tell us that enthusiasm about a global economic transformation is misplaced, another investing fad that’s come and gone? Far from it. Let’s recall what that transformation is all about, what risks it now faces, and what issues investors need to account for in trying to participate in its more promising aspects.
Something very important is occurring in the global economy, and it’s happening at an astonishing speed. Economists view growth in per capita wealth from about $1,000 to about $2,000 (in current U.S. dollars) as marking a country’s development from poor to middle income. The U.S. and Great Britain attained that $2,000 mark in the mid-nineteenth century; it took about 100 and 200 years, respectively, to do so. Countries such as China, India, and Indonesia didn’t manage that same doubling of average wealth until the late twentieth century, but, astonishingly, it took them less than twenty years. In the process some forty percent of the world’s population has moved from subsistence agriculture to at least the bottom rungs of middle-class production and consumption. And it’s not just the bottom rungs that have grown. An estimated forty percent of luxury goods demand now comes from the emerging markets. Visit Shanghai. While Westerners flock to the supposed local bargain emporia, newly prosperous local consumers fill the European luxury boutiques—that is, the Shanghainese who aren’t shopping in Paris’s Faubourg Saint-Honoré.
As important as what has already been accomplished is what remains to be achieved. For all China’s remarkable growth, it remains a very poor country. U.S. per capita GDP, even adjusted for purchasing power, is 5.8 times that of China. Only the top three percent of India’s population enjoy incomes greater than the poorest one percent of the U.S. population. But it appears time and far more youthful populations are on the side of those economies. McKinsey and Company estimates that while emerging economies account for about 36 percent of global GDP now, that share will nearly double by 2015. I believe when wealth creation occurs at that pace, opportunities will abound for investors.
With all that wealth created and left yet to be created, why haven’t investors in emerging market equities done better? There are at least three reasons, each of which offers some guidance to investors who can take a longer term view of these markets.
The first problem is that economic growth and stock market performance have surprisingly little relationship. Historically the countries with the fastest growing economies haven’t systematically enjoyed the highest domestic stock market returns. Those fancy European labels are an example of why. An Indian household’s first purchase of commercial laundry detergent may mean revenues in Cincinnati rather than close to home. Many of the companies that profit from growth in the emerging economies will be the ones who speak the local language, understand the local bureaucracy, and can navigate through the local transportation bottlenecks, but many others will have the power of prestigious brands and advanced technology but foreign postal addresses. Successful investors will need to understand both.
Second, emerging market investments sound risky, and the past year or so has been a time when many investors have shown an aversion to risk. Oddly, the source of that risk aversion has had more to do with the ongoing European debt debacle and America’s inability to find a durable approach to its own tax and spending policies rather than the health of emerging economies themselves. Many supposedly less-developed countries enjoy much more manageable debt levels and fiscal balances than do the U.S., Europe, or Japan, but worries about the latter countries have drawn investors toward traditional safe-haven investments such as U.S. treasury bonds. So far so good, but that slip in logic may someday exact a price from investors.
Finally, growth has slowed in several of the largest emerging markets, China and Brazil most notably. In part, slowing reflects last year’s policy decisions to avoid overheating and inflation, as well as decelerating demand from the U.S. and Europe mixed with an ongoing shift from the export of cheap products and raw materials toward production aimed at domestic demand. As economies mature, even a decade of rising tides won’t raise all ships. There will be winners and losers, and investors will continue to face a challenge in recognizing which is which.
When we look back at this decade and ask what the most important economic issue of the ‘10s turned out to be, I doubt it will be the U.S. fiscal cliff or Greece’s continued use of the euro. I expect it will be the relative success of the countries we (already anachronistically) call “emerging,” and, for investors, success in capturing a bit of the benefit of this vast source of wealth creation.
Jerry Webman is the author of MoneyShift: How to Prosper from What You Can't Control and Chief Economist at OppenheimerFunds.