Over the last ten and twenty year periods, emerging market stocks have outperformed the developed markets, whether the U.S. or international developed markets. However, so far in 2011 the emerging markets, as represented by the MSCI Emerging Markets index, have dropped 20%, which is much worse than the developed international market drop of 9% or the flat performance of the S&P 500. So this looks like a good time to take a closer look at the appeal of emerging markets.
Emerging markets predominantly consist of Latin America, Eastern Europe, and most of the Asian markets outside of Japan. The largest individual countries represented are the so-called BRIC countries of Brazil, Russia, India, and China. Taken as a group, the fundamentals of the emerging market countries have long looked appealing because of rapid population growth, huge labor cost advantages, and fast economic growth off a relatively small base. Their persistently faster growth means that emerging markets now represent one-third of total global output. The trade-off for emerging markets faster growth has been higher risk as those markets have typically been much more volatile than developed markets. Historically this reflects greater political instability, weaker financial underpinnings, less stable currencies, and immature capital markets.
The emerging market advantages remain intact today, although they have evolved and in some cases grown. The demographics of the emerging markets still look favorable, particularly in contrast to the developed markets which are increasingly burdened with an aging population that brings with it rising pension and health care costs. The labor cost advantage in the emerging economies has lessened over time and the growth rate has inevitably slowed as the economic base has expanded, but the bigger base has brought with it an increasing median income which is gradually fostering a domestic consumer market. Ironically, sovereign debt ratings for emerging market countries have been steadily improving over the last several years while developed market countries have seen their ratings steadily slipping. According to the International Monetary Fund, emerging market countries have a public debt to GDP ratio of about 30% and falling while developed countries have a ratio of 115% and rising. So while voluntary or forced deleveraging at the personal and government level is a drag on growth in the developed markets, emerging markets face no such problem. In a related vein, in the event of a sharp slowdown in growth, the debt load of developed markets will greatly hamper their ability to respond with fiscal stimulus while emerging markets still have this in their toolbox. Similarly, extremely low interest rates in the developed markets mean monetary policy for them is largely impotent at this time, while interest rates are much higher in the emerging world, leaving room for cuts should slowing economic conditions dictate that medicine. It bears noting that the main reason interest rates are higher in emerging markets is because inflation is higher in these countries. Food price inflation is a particularly delicate economic and political problem in most of these countries because the average consumer spends a far greater portion of their income on food than do developed market consumers.
Despite growing domestic consumer markets, emerging market countries remain predominantly export oriented so they are vulnerable to economic weakness in the developed world. Nonetheless, with emerging markets selling at valuation levels roughly 20% cheaper than developed markets, and their long-term fundamental advantages over developed markets intact, if not widening, expanding their representation in client portfolios is a move we’re studying closely.