Emerging markets` siren song

Emerging markets might just be that most dangerous of things to an investor - an easy to understand but ultimately too-expensive story.

It has been a bad year for emerging market equities, which have fallen hard and mostly because of news originating in the developed world, as fears over the euro zone and US debt downgrades all sentiment.

The broad MSCI index of emerging market shares has dropped about 17 percent over the past year, against a three percent gain in the S&P 500.

Shares in Brazil, Russia, India and China, the so-called BRIC emerging markets, have done even worse, down more than 20 percent in the past year. They have even underperformed the euro zone, whose stocks are down only about 14 percent.

That must come as a bitter irony to investors in emerging markets, many of whom were drawn to the asset class specifically because of how it`s different from more mature markets.

The emerging markets selling proposition is crisp, clean and easy to grasp; better development prospects driving better growth and all without the huge overhang of debt. Who, after all, wouldn`t want to be exposed to a population which saves, is productive and has a huge capacity to increase consumption over time? This gives emerging markets to room to grow in a new way, through domestic consumption, rather than by making things cheaply and exporting to the already-saturated markets of the US and Europe.

This is just the sort of thing that wealth advisors don`t just pitch to their clients, but find their clients pitching to them.

A seductive thesis, but then again, so were dotcom stocks.

The dotcom "story" was a true one, in the end, but not without lots of creative destruction and not without huge amounts of overpriced IPOs.

"Once investors get an idea into their heads, it is very difficult to dislodge," Albert Edwards, strategist at Societe Generale, writes in a note to clients.

"The problem I find is that investors are desperate to believe the emerging markets and BRIC growth story, for they have so little alternative. The story of superior growth for the emerging markets universe is as entirely plausible as it is entirely misleading. Valuation is what matters for investing in emerging markets, not their superior growth story. Certainly emerging markets equities are not relatively cheap."

The future is rising in price

And while emerging market equities certainly were cheap compared with those of their developed peers for many years, that`s no longer true.

If you look at either price-to-book or forward price-to-earnings ratios, emerging markets were relatively inexpensive until about 2007, at which point the gap narrowed, at least in part because investors came to believe in the idea that they could "decouple" from the low growth developed world. As it stands now, emerging shares are slightly cheaper, but nowhere near as cheap as they were a decade ago.

Of course, that might be because the hype is real, and investors are thus willing to pay for the superior growth prospects in emerging markets, while still slightly discounting them for a variety of reasons, such as corporate governance, liquidity and currency risk.

As well, since so many investors in the developed world are only slightly exposed to emerging markets, there is a weight-of-money argument that says valuations in emerging markets, which have a much lower market capitalization than the developed world, shouldn`t be cheap. In other words, if everyone moves just a small slice of their assets to emerging markets, valuations will continue to rise.

If growth is what we are paying for in emerging markets, there are reasons to worry, with signs of a sharp slowing in Brazil, India and China.

The strong signs of a slowdown are especially troubling in China. A lull in growth there would hit valuations and reverberate through the rest of the emerging market universe.

China`s manufacturing sector shrank in November, according to two surveys released on Thursday, hit by drops in demand both domestically and internationally. As well China cut its reserve requirement for banks, making loans cheaper and easier to get, for the first time since the dark days of 2008. So much for decoupling.

All of this indicates that though emerging markets may have a bright future once domestic demand takes off, for now they remain a leveraged and riskier play on growth and demand in the US and Europe.

Perhaps, as so often, the simplest advice is the best.

Bureau Report

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