In the late ’90s, the dramatic underperformance of those assets occasioned much despair. As emerging markets started to rally in early 2003, few believed in their staying power. But then, almost inevitably, came a moment of ebullience, when earlier this year big U.S. retail investment funds began moving in. During the eight months ending in April, their investments alone in emerging markets exceeded the cumulative inflows of the entire previous 10 years.
Alas, how brief it was. With the average emerging-market fund losing a fifth of its value over the past three months, some investors now wonder whether we’ve entered the final, fatal stage of Templeton’s classic manic-depressive cycle. Exuberant talk of a potential “new era” for emerging markets has given way to pessimism. Markets are replete with warnings: how overbought emerging markets have become, how prone they are to boom-bust cycles. News headlines suggest a financial crisis might be looming for the developing world, from equities to commodities.
Evidence of any such reversal, however, remains scant. Any major bull market typically ends in excess: extreme valuations, often accompanied by a rapid pickup in inflation. The fact that after a 200 percent gain, it took just a 20 percent decline to rekindle old fears about the vulnerability of emerging-market equities is–in a perverse way–a positive sign. Many investors haven’t yet bought in to the theory that developing countries are approaching the end of their boom-bust cycle. To the contrary, violence suggests they are still in the phase of “grow on doubt, mature on optimism.”
Even at their May high, the picture for emerging markets was very different from the tech bubble of 1999, or even Japan in 1989. In those bull markets, investors assigned ridiculous multiples to stocks. Contrast that to current emerging-market multiples. It’s hard to recall any bull market that peaked at a price-earnings ratio of 12.
To be sure, profit margins in emerging markets are elevated. Earnings growth can’t continue at the breakneck pace of the past three years. But cycles don’t end just because earnings growth goes off the boil, nor do serious bear markets occur when corporate balance sheets are in such great health. They come, instead, when companies spend excessively during a boom, leading to excessive debt. So far, most emerging-market firms have been slow to step up capital spending. They are brimming over with cash flow and using the funds to pay down debt.
In most developing countries, that corporate discipline has been matched by admirably responsible government policy. Result: emerging-market nations, in aggregate, are running surpluses on their fiscal and balance-of-payments accounts. Inflation thus remains low, suggesting that (in addition to sound fiscal policies) another factor is at work: an underlying advance in productivity. Couple this with an embrace of both globalization and free-market economics, and the indications are that the boom in emerging markets isn’t likely to end any time soon–certainly not after just three years.
This is likely to be the decade of emerging markets. Yes, we will experience cycles. Severe shakeouts, even mini bear markets, punctuate all great bull markets. At times, tremors are required to remind us of some basic rules. Among them: that many analysts forget how important a role the United States plays in the global economy. The U.S. recovery that began in mid-2003 laid the foundation for the current emerging-market boom. Each time U.S. markets wobbled in the past three years, emerging markets lost too.
The hope is that this is 1994 redux. Back then, led by the U.S. Federal Reserve, central banks raised interest rates sharply and ended a protracted period of easy money. By the end of that year, markets with strong underlying fundamentals (such as American equities) were left standing, while the liquidity hothouses (emerging markets) never quite recovered. Today, in a possible role reversal, emerging markets are likely to emerge as the asset class of choice in this decade. Investors may well be surprised by how resilient many developing economies will prove to be in the face of monetary tightening.
What’s different, then and now, is that emerging-market growth over the past three years has not been a liquidity-driven cyclical phenomenon. Reflecting these markets’ sound policies and fundamental financial health, global investors will become more willing to re-rate them. Once they see that growth in emerging markets is more resilient than anticipated in the face of all the monetary tightening, they will be increasingly willing to attach a higher price-to-earnings multiple to these assets than in the past, reflecting a more mature sense of their riskiness and long-term future. The boom, in other words, will go on.
