Even in the midst of an ongoing Euro-zone crisis with no obvious solution in view, investors have no trouble distinguishing between one European country and another, as the yield spread between German and Greek government debt (currently 860 basis points, or 8.6 percentage points) clearly demonstrates. Why, then, are investors so amazingly dense by comparison when it comes to emerging markets? Why do they – willfully, it seems – refuse to recognize that there are huge differences between, say, Chile and Venezuela, which lumping them together into an emerging markets basket or a Latin America basket can only obscure?
Ten days ago, while the Egyptian democracy movement was still gathering steam and uncertainty abounded as to the political fate not only of Egypt but of the entire Arab world, the Financial Times reported that investors had pulled more than $7 billion out of emerging markets equity funds during the preceding week. This was the biggest withdrawal in over three years, which the FT attributed to “turmoil in the Middle East and rising food inflation [which] raised fears of economic instability.” Egypt, it said, may have been the catalyst, “but the fund outflows also reflected deeper unease about economic overheating in China, India, Brazil, and other big emerging economies.” The article went on to quote several fund managers who said that developed markets now represent greater value than emerging ones and as proof pointed out that nearly all of the $7bn lost to emerging markets had been reinvested into funds focused on the United States, Europe, and Japan. Though the magnitude of emerging market outflows and developed market inflows during the week of January 31 was the biggest so far, it was the fifth consecutive week in which investors had fled emerging markets for the relative safety of the big developed markets. Apart from political turmoil, investors apparently were spooked by rising inflation in emerging markets. The proof? Indonesia, Brazil, India, and South Korea have all raised interest rates this year.
True enough, emerging market indices overall are down this year: the Morgan Stanley Emerging Markets Index (MXEF:IND) was down by about three per cent when the FT article was written; yesterday it closed five per cent down for the year. Signs, to be sure, of a self-fulfilling prophecy. Further signs, if any were still needed, that over the long term throwing darts at the stock market pages will produce higher yields than entrusting your money to most fund managers, and it will cost you a whole lot less.
Although their ads always contain the disclaimer that past performance is no guarantee of future results, few money managers act as if they believe it. The U.S. and European equity markets grew like gangbusters in 2010, mainly because they had fallen so far in 2008 and 2009. Some markets, like Denmark, registered gains that would have made any emerging market proud. All three U.S. indices showed double-digit gains for the first time in years.
Many emerging markets, which suffered much less, if at all, from the global financial crisis, did not have as far to rebound. The MSCI Brazilian stock market index gained only 3.8% last year, while the MSCI Egyptian index was up about 9.5% – respectable, but not the kind of blistering return emerging markets investors seem to think is their birthright. So far this year, the Egyptian index had fallen more than 20% by the time the exchange halted trading on January 27.
There is a well-known statistical term called reversion to the mean, which holds that if a variable is extreme on its first measurement, it will tend to be closer to the average on a second measurement, and if it is extreme on a second measurement, will tend to have been closer to the average on the first measurement. There are all kinds of caveats about using this as a principle to guide your investing behavior but, put simply, it means that if a market gains or loses a huge percentage – say, 60% – in a given year, it is unlikely to do so the next year. Over time, values are likely to revert to their long-term trend line of growth, stasis, or decline. Put another way, if you pour all your money into a Danish market index fund at the beginning of this year, expecting a repeat of 2010’s gain of 29.81%, you are likely to be disappointed. Although I am a big fan of Thailand, whose stock market, in spite of tremendous civil unrest last summer gained over 50% in 2010, I don’t expect it to rise that much this year.
So if you are tempted to follow the herd and stampede out of emerging markets into more mature North American and European markets, bear a few things in mind: 1) the inflationary pressures that have investors worried about emerging markets are equally present here at home. The difference is that our CPI strips out energy and food when measuring “core inflation,” so the numbers don’t look so bad; 2) Dilma Roussef, the successor to former Brazilian President Luis Ignacio Lula da Silva, who everyone feared would be more populist than her predecessor, raised interest rates to head off inflation. We can’t do that in the U.S. for fear of choking off a weak recovery; 3) As today’s New York Times reports, core inflation in the U.S. is almost certain to rise in the coming year as sharp hikes in prices for energy and other commodities start to be reflected in prices for final consumer and industrial goods.
If you’re investing with a very short time horizon you probably don’t belong in emerging markets. In spite of the many falsehoods bandied about, it is certainly true that they are more volatile than most mature markets. But if you have a medium to long horizon, ask yourself which equity markets are likely to perform best over the next 10 or 20 years, and make your choice accordingly. Nathan Rothschild said, “Buy when there’s blood in the streets.” Now could be a good time to buy.