The question now is whether this reversal in sentiment paves the way for investors to buy back into faster-growing markets at what remain, on a five-year view, cheap valuations. Emerging stock markets have underperformed their Western peers by nearly 30 per cent since late 2010, leaving them on much lower earnings multiples. China is forecast by the IMF to grow at 7.5 per cent this year. Surely the combination of fast growth and cheap stocks - the MSCI index for China trades on 9 times 2014 earnings forecasts - points to a valuation anomaly?
Such an analysis is seductive but sadly simplistic. Emerging-market stocks outperformed developed-world peers so strongly in the years running up to 2008 that their recent underperformance leaves them looking no better than fairly valued on a longer-term view. And it’s not just the quantum of growth that matters, but its path. Growth expectations for China may now stand at 7.5 per cent, but they used to be considerably higher - and, crucially, seem likely to fall further.
That’s because China’s government has outlined the explicit goal of replacing investment with consumption as the growth engine of the economy. And it would be unprecedented for consumption spending to grow at 7.5 per cent. Andrew Cole of Baring Asset Management reckons the sustainable level of Chinese growth is 5-6 per cent. The ongoing downgrade cycle this implies is the key reason he gives for avoiding emerging market equities in the fund manager’s multi-asset portfolios.
The problems faced by other countries are slightly different. The latest emerging-market generalisation coined by investors is the "fragile five", comprising Brazil, India, Indonesia, South Africa and Turkey. These countries all ran current-account deficits - their imports outweighed their exports - during the good times, leaving them dependent on foreign capital. When the market mood reversed last May, their currencies collapsed, forcing them to hike interest rates. Tight money, inevitably, has constricted consumer spending and business investment, weighing on growth.
This narrative will be familiar to those who have followed emerging markets over the years. As a recent research note from fund manager Schroders points out, it also follows the pattern of the financial crisis that hit the US and UK in 2008, and moved to the eurozone periphery in 2011. In all three cases, "a surge in investment created a bubble which subsequently reversed as credit conditions tightened," writes chief economist Keith Wade.
Developed economies have used ultra-loose monetary policy to ease the path back to prosperity - at least for asset-owners. Because it runs a current-account surplus, China could do the same, but won’t; it needs to tame the animal spirits unleashed by its 2009-10 stimulus package. The fragile five, however, are in a more precarious position with international creditors, leaving them little option but to live with tighter money. The path of readjustment may be commensurately less profitable for investors.
Taking a longer-term view, it is important to recognise that emerging markets are not pre-destined to emerge into the developed world. Those that do - such as South Korea - are the exception, not the rule. It is sobering to recall that conversations about emerging markets in the 1970s would likely have included references to countries like Zimbabwe, Venezuela and Pakistan. China was the basket case back then.
There is still a place for emerging markets in the portfolios of private investors - not least because they seem to perform out of synch with developed markets, making them a useful diversifier. But investors cannot rely on the blanket assumption that they are due to 'converge' with richer peers. Instead, they need to work out which economies look better placed to perform (Poland, say) and remain alive to a changing outlook (will Modi transform India?).
Answering these questions requires a lot of work. Most private investors are probably better off outsourcing the job to a fund manager, who can choose not only the more dynamic countries, but also the more dynamic sectors of what are often immature stock markets, heavy on former state-owned enterprises, resource companies and banks. The average emerging-market fund has beaten the MSCI index over the past three difficult years. This is one area where the professionals easily justify their fees.
For more Taking Stock columns from Stephen, click here.
