Will 2012 be emerging markets’ year?

Emerging markets were a great disappointment in 2011, but can they come good this year? The argument in their favour is familiar; indeed it has been the same for almost 20 years. Developing economies are growing faster than developed ones.

But as investors know all too well, such growth does not automatically translate into higher returns. Last year, for example, emerging market equities delivered a return of minus 21 per cent. Sentiment towards the region deteriorated rapidly by the end of the year. According to Crossborder Capital, some $2.75trn (£1.75trn) was taken out of the sector in the last four months of the year. This was the biggest outflow since the Lehman crisis.

It was not that the economies didn’t grow. China is likely to record its customary 9 per cent GDP boost, with India on 7 per cent, Brazil on 3 per cent and Mexico on 4 per cent. The main problem, however, was an increase in pricing pressures that saw Chinese inflation hit 5.6 per cent, Brazil 6.7 per cent and India over 9 per cent. This led to a degree of tightening in monetary policy, which proved pretty negative for risky assets.

The emerging market investment cycle is pretty well established. Investors become enthusiastic about the sector’s prospects and push up valuations, and then there is a shock that knocks valuations back down. The trigger seems to occur when emerging markets trade at a premium to developed valuations. At such moments, many people argue that such a premium is justified, because of the superior growth prospects; and perhaps a premium will be the norm in the long run. But emerging markets remain less liquid than their developed counterparts and corporate governance standards are generally lower.

That makes them more volatile, and more risky, and thus deserving of a general valuation discount. But the good news is that last year’s decline has re-established that valuation discount. According to HSBC, at the end of 2011 emerging markets were priced at 10.3 their historic earnings, compared with a developed world ratio of 12.4. Analysts are forecasting 10 per cent growth in profits in the emerging world this year, but estimates have steadily been slashed in recent months, so that may well be an overestimate.

Nevertheless, there will be one tailwind in 2012. As commodity prices retreated in late 2011, many developing countries are starting to ease monetary policy. India cut the cash reserve ratio of banks by 50 basis points on January 24 (a step that will allow banks to lend more money) and interest rate cuts may follow. China tightened monetary policy sharply last year, to slow a housing boom, but it has been lowering the bank reserve ratio and is expected to go further. The Philippines cut interest rates in January.