Many economists believe this isn't merely a short-lived downturn, nor one confined to China. Economic consultant John Llewellyn warns of "continued fragile and sub-par" growth in the Brics (Brazil, Russia, India and China) this year and next. Others fear that growth might be shifting to a permanently slower rate. Lant Pritchett and Larry Summers, two US economists, have warned of "substantial slowdowns in China and India." And Anders Aslund at the Peterson Institute for International Economics says: "We should expect much lower growth rates in the emerging economies over the next decade."
There's a simple reason for this. When a country is dirt-poor it can grow simply because its low wages give it a cost advantage over the rest of the world. As wages rise, however, this advantage fades. Then, the forces that kept the country poor in the first place - such as lousy infrastructure, poor education, corruption or bad government - re-assert themselves. Nations can therefore fall into a middle income trap in which initially fast growth gives way to stagnation: this has been the fate of, for example, Brazil, Mexico or Indonesia.
What would this mean for UK investors in emerging markets? It's tempting to think: not much. Research shows that over long periods there is no correlation across countries between GDP growth and equity returns. "Countries with high growth potential do not offer good equity investment opportunities unless valuations are low" concluded the University of Florida's Jay Ritter in one study.
I fear, though, that such a view might be too complacent. One reason for the lack of correlation is that share prices discount expected growth. But this implies that surprisingly weak growth could come as a nasty surprise and so depress prices.
Nevertheless, there are still reasons to be interested in emerging markets.
One is that they diversify risk. This might seem odd; the main emerging markets are more volatile than western ones and often fall more when developed markets do badly. But it isn't. There's one risk facing western economies which emerging markets might help protect us from - the danger of secular stagnation.
It's possible that western economies will suffer years of slow growth because of a lack of profitable investment opportunities. If so, we face the possibility of poor returns not just on equities but also on our human capital, as we see a risk of job loss or stagnant real wages; think of the fate of Japan since 1990. Investing in emerging markets might help diversify this double risk, because the danger of them falling into a middle income trap is largely independent of the danger of secular stagnation in the west.
Emerging markets - and especially the very poorest ones - also offer us something else. Common sense tells us that stock markets in poor countries should offer high returns even if they don't see rapid GDP growth.
The reason for this is simple. The poorer you are, the riskier are shares because you are less able to withstand losses. If a fall in the stock market merely means you have to book a slightly less luxurious cabin for your world cruise, it is only a slight nuisance. But if it means you have to take your children out of school, it is a disaster. This means that, in poor countries, shares are more unattractive to the marginal investor - which implies that share prices will be low and expected returns will be high for the few investors able to bear risk. Economists have given this common sense a fancy name: the consumption capital asset pricing model.
This theory better applies to the least developed markets where the marginal investor is more likely to be a local and less likely to be a western-based fund manager. It is therefore a case for preferring frontier markets to the Brics.
But is the theory true? It's actually hard to say. Since its inception in November 2002 MSCI's index of frontier markets has risen 9.1 per cent per year. That's better than the 6.3 per cent annualised gain in developed markets - consistent with the consumption CAPM - but less than the 10.3 per cent rise in emerging markets, which is not so consistent.
However, it's possible that during this time emerging markets have had unusually good luck and frontier markets bad, so this sample isn't a reliable indicator of true returns. Because stock markets are very volatile, even 13 years is too small a sample from which to make robust inferences about true returns. During this time the standard error of annual returns on frontier markets has been 5.5 percentage points, that on developed markets has been 4.3 percentage points, and that on emerging markets has been 6.3 percentage points. These sampling errors are so big that it's quite possible that frontier markets do indeed do better than emerging markets which in turn do better than developed ones - just as the consumption CAPM implies. As the University of Chicago's John Cochrane says, there might well be some truth in the theory.
We can't say how much, though. However, when we are faced with the possibility that emerging markets no longer offer strong growth, it is this theory that offers a better reason for investing in them.
