Only a year ago sentiment about emerging market equities was overwhelmingly optimistic. Today pessimism is rife, though not yet uniform. On the S&P Global Broad Market Index emerging markets were down 17.6 per cent in the year to July 31, while overall global markets were off only 6.7 per cent. What is it that has caused emerging markets to submerge?
Part of the problem is that expectations have been pitched too high. The emerging markets had a great crisis. After being badly hit by a capital exodus and credit crunch, along with a devastating collapse in world trade, China, India and Brazil in turn staged an astonishingly robust bounce back, quickly followed by others.
An impressively prompt fiscal and monetary response drove the recovery. Many larger economies also enjoyed the stabilising benefit of substantial currency reserves and lowly leveraged corporate and household balance sheets, reflecting the lessons learned in the Asian crisis of 1997-98. They thus escaped the debilitating impact of deleveraging that has marked the anaemic recovery in the developed world.
The immediate problem is a cyclical slowdown. The big emerging market stars, notably China, India, Brazil and Turkey, have seen much slower rates of growth this year than they have been used to. Export momentum has weakened in response to the dismal plight of the eurozone. Food price inflation has become a serious problem, while some countries are also seeing a rise in the level of non-performing loans in the banking system.
Policy is once again being eased, though not on the scale of 2009. And that in turn creates structural problems since it will delay a shift away from an unbalanced growth model whose utility is increasingly in question. In China and many other Asian economies rates of investment are running at unsustainably high levels, creating additional capacity in industries that already have more than enough, while generating construction booms that litter the landscape with ghost towns and empty apartment blocks. Crank starting the economy with the same flawed tools simply piles up problems for the future.
In the case of India the balance needs to shift the other way towards investment, while in many commodity producing countries the challenge is to foster a competitive non-commodity sector to counteract the adverse impact of natural resource windfalls on the exchange rate and resource allocation. As the experience of the UK with North Sea oil shows, this is extraordinarily difficult even for countries with strong institutions and governance.
A more fundamental ground for pessimism comes from the Harvard economist Dani Rodrik, who argues that recent rapid growth in emerging markets is the exception, not the rule. Economic miracles in developing countries have relied on a tried and tested formula since the start of the industrial revolution – shifting labour from land to manufacturing.
Manufacturing plays the key role because it is relatively easy to copy foreign production technologies. High productivity services, by contrast, require complex skills and institutional infrastructure.
The difficulty for new entrants into the globalisation process, says Mr Rodrik, is that manufacturing has become more skill and capital intensive. So it is becoming much harder for manufacturing to absorb labour from rural areas. And the rules of the globalisation game are changing. For years the west was content to export capital and technology to the developing world, while standing ready to absorb its exports.
Yet today the impact of countries such as China entering global markets is so great and the resulting de-industrialisation in the developed world so painful that western politicians have diminishing enthusiasm for a liberal trade regime.
If you accept these premises, it follows that emerging market growth will be more dependent on human capital, institutions and governance than in the past. That leads to the conclusion that growth will be slower and more difficult than many investors have assumed.
None of this should be taken to imply that there will be no investment opportunities in the developing world. For a start, the current pessimism does not extend to bond markets where yields on some emerging market sovereign debt have been driven down to levels that smack of a bubble. The enlargement of quoted corporate sectors and improvements in governance will also ensure continuing interest in emerging market equities.
The question is rather whether the expectations of the investment community have adequately adjusted to the possibility that the growth performance of emerging markets over the past dozen years may not be repeated.