Don’t Count on Emerging Markets

History shows painfully slow growth.

June 21, 2010

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830761_watch_out_old_peopleLong-term data series about stock and bond returns are the lifeblood of financial consultants and stock mavens alike. Continually, they reinforce the mantra: bonds beat cash, stocks beat bonds – over the long term.

That’s not likely to be of much solace for stock investors who have seen flat or negative 10-year stock returns – except in such places as Canada and the emerging markets.

So what’s different this time?

Elroy Dimson, Paul Marsh and Mike Staunton,  researchers at London Business School, in their annual  Credit Suisse Global Investment Returns Yearbook 2010, have some suggestions.

“Emerging markets have been the hot topic of the past year, but the story line has evolved. In the turmoil of 2008 and early 2009, they crashed along with, and more than, other risk assets, shaking investors’ faith in the decoupling theory and in diversification as a way of safeguarding portfolio values.

“In the staggering equity market recovery since March 2009, the picture changed. Belief in decoupling was back as emerging markets recovered sooner, faster and further, and became the world’s engine of growth and recovery. The belief that “future growth means higher returns” gained momentum. Meanwhile, the financial crisis shattered the preconception that the USA and other developed markets were relative safe havens. Investors now viewed the risk gap between emerging and developed markets as much smaller. Are these perceptions correct, and have events been so paradigm-changing that emerging markets are now the only game in town?”

First, much is in the hands of the index providers. There can be a failure to launch, or as Dimson et al. Note: “Clearly several markets have failed to emerge as rapidly as once hoped.”

A little bit of history helps illuminate this. Dimson et al. key in on GDP per capita as a measure of development and then look back through their database to 1900.

“Using this criterion, only seven of the 38 countries with equity markets in 1900 changed status over the following 110 years. Five markets moved from emerging to developed: Finland, Japan and Hong Kong plus, more recently, Portugal and Greece.  Two moved from developed to emerging: Argentina and Chile. Of the remaining 31 countries, 17 would have been deemed developed in 1900 and remain developed today, while 14 were emerging and are still in that category 110 years later.”

Yes, growth happens, the authors conclude, with this proviso: “although most countries have grown considerably in terms of GDP per capita, their relative rankings on this metric have changed far more slowly.”

The demotions are significant in their own right: “There are numerous historical reasons why many emerging markets have emerged slowly, and why others have suffered setbacks. These include dictatorship, corruption, civil strife, wars, disastrous economic policies and hyperinflation, and communism. A combination of several of these factors helps to explain why Argentina, which in 1900 had a GDP per capita similar to that of France, and higher than Sweden and Norway, is now categorized by MSCI as just a frontier market.”

Sometimes, things are different this time.

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