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Buttonwood
The last great hope
Sep 30th 2010
THE internet allowed people to pay lower prices for books but also encouraged
them to pay stratospheric prices for shares in lossmaking dotcom companies.
During the subprime boom Americans believed the illusion that they could get
rich by buying each other s houses.
Those dreams may have been shattered. But hope springs eternal. There is still
one great hope left for investors: emerging markets. Fund managers have been
making the case for emerging markets on a regular basis over the past 20 years.
Developing countries offer higher economic-growth rates, have younger, more
dynamic populations and are under-represented in the global stockmarket. Buying
a stake in emerging markets is like buying a stake in the future.
Goldman Sachs, for example, reckons that the total capitalisation of emerging
markets will rise from $14 trillion today to $80 trillion by 2030, increasing
from 31% of the global total to 55% in the process. Even allowing for new
equity issuance, that will still translate into an annualised return of 9.3%,
Goldman estimates, compared with just 4% for developed markets. It seems like a
no-brainer.
But experience should teach investors to be suspicious of no-brainer decisions.
The same arguments were advanced in the early 1990s, after all. But between
1991 and 2000 emerging markets delivered a total return of just 38% and
developed markets returned 171%. Outperformance came only in the decade just
gone, with emerging markets almost quadrupling investors capital since the end
of 2000.
A caveat also needs to be applied to the growth case. Elroy Dimson, Paul Marsh
and Mike Staunton of the London Business School examined their database of 17
national stockmarkets since 1900. Using a variety of tests, they found
virtually no correlation between an individual country s GDP growth rate per
head and the returns to investors.
What is the explanation for this rather counter-intuitive result? One answer is
that a stockmarket is not a perfect facsimile of an economy. Many companies are
unquoted. Those businesses that have floated on the market may be mature, or
slower-growing, or simply overweight in one sector. In 1900 Wall Street was
dominated by railroad stocks, for example.
A second answer is that growth countries may behave like growth stocks. A
period of strong performance leads to overvaluation, from which subsequent
returns are inevitably disappointing.
Has that stage arrived? The old rule of thumb was that emerging markets were
pricey when they traded at a higher multiple of profits than their developed
counterparts, as they did in 1999 and 2007 just before sharp falls in prices.
At the moment they trade at a modest discount.
But emerging markets are prone to boom-and-bust cycles. They have suffered
three 25%-plus losses in the past 20 calendar years, and five years in which
annual returns have exceeded 50%. International investors have probably been
behind much of the volatility, pushing the markets this way and that as they
switch between enthusiasm and risk aversion.
It is quite possible that another boom is on its way. Bubbles, as described by
Charles Kindleberger, a financial historian, usually involve an initial
displacement, followed by rapid credit creation and then a phase of euphoria.
The displacement may have been the financial crisis of 2007-08 which undermined
the solvency of the developed world. As governments propped up their banks,
their debts soared. On average emerging-market governments now have much lower
debt-to-GDP ratios than their developed peers. Economic power seems to have
made a decisive shift.
The crisis was followed by the slashing of interest rates in the developed
world. These have had a limited effect in reviving lending in Western
economies. But they have encouraged Western investors to buy higher-yielding
assets, like emerging-market equities. Emerging-market equity funds have
already received inflows of $45 billion this year, according to EPFR Global, a
research group. And low rates will also boost credit creation in those
developing countries that import American monetary policy via managed exchange
rates.
Euphoria will follow as cheap money drives up asset prices this may have
already happened in parts of the Asian property market. Investors probably have
no option but to ride the wave, if only because the outlook for developed
markets looks so flat. There is, at least, more solidity to emerging markets
than there was to dotcom stocks.