THE internet allowed people to pay lower prices for books but alsoencouraged them to pay stratospheric prices for shares in lossmakingdotcom companies. During the subprime boom Americans believed theillusion 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 aregular basis over the past 20 years. Developing countries offer highereconomic-growth rates, have younger, more dynamic populations and areunder-represented in the global stockmarket. Buying a stake in emergingmarkets is like buying a stake in the future.
Goldman Sachs, for example, reckons that the total capitalisation ofemerging markets will rise from $14 trillion today to $80 trillion by2030, increasing from 31% of the global total to 55% in the process.Even allowing for new equity issuance, that will still translate intoan annualised return of 9.3%, Goldman estimates, compared with just 4%for developed markets. It seems like a no-brainer.
Butexperience should teach investors to be suspicious of no-brainerdecisions. The same arguments were advanced in the early 1990s, afterall. But between 1991 and 2000 emerging markets delivered a totalreturn of just 38% and developed markets returned 171%. Outperformancecame only in the decade just gone, with emerging markets almostquadrupling 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 examinedtheir database of 17 national stockmarkets since 1900. Using a varietyof tests, they found virtually no correlation between an individualcountry’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 aneconomy. Many companies are unquoted. Those businesses that havefloated on the market may be mature, or slower-growing, or simplyoverweight in one sector. In 1900 Wall Street was dominated by railroadstocks, for example.
A second answer is that growth countries may behave like growthstocks. A period of strong performance leads to overvaluation, fromwhich subsequent returns are inevitably disappointing.
Has that stage arrived? The old rule of thumb was that emergingmarkets were pricey when they traded at a higher multiple of profitsthan their developed counterparts, as they did in 1999 and 2007 justbefore sharp falls in prices. At the moment they trade at a modestdiscount.
But emerging markets are prone to boom-and-bust cycles. They havesuffered three 25%-plus losses in the past 20 calendar years, and fiveyears in which annual returns have exceeded 50%. Internationalinvestors have probably been behind much of the volatility, pushing themarkets this way and that as they switch between enthusiasm and riskaversion.
It is quite possible that another boom is on its way. Bubbles, asdescribed by Charles Kindleberger, a financial historian, usuallyinvolve an initial displacement, followed by rapid credit creation andthen a phase of euphoria.
The displacement may have been the financial crisis of 2007-08 whichundermined the solvency of the developed world. As governments proppedup their banks, their debts soared. On average emerging-marketgovernments now have much lower debt-to-GDP ratios than their developedpeers. Economic power seems to have made a decisive shift.
The crisis was followed by the slashing of interest rates in thedeveloped world. These have had a limited effect in reviving lending inWestern economies. But they have encouraged Western investors to buyhigher-yielding assets, like emerging-market equities. Emerging-marketequity funds have already received inflows of $45 billion this year,according to EPFR Global, a research group. And low rates will alsoboost credit creation in those developing countries that importAmerican monetary policy via managed exchange rates.
Euphoria will follow as cheap money drives up asset prices—this mayhave already happened in parts of the Asian property market. Investorsprobably have no option but to ride the wave, if only because theoutlook for developed markets looks so flat. There is, at least, moresolidity to emerging markets than there was to dotcom stocks.