Why have global emerging markets underperformed? It is probably fair to say that many investors accept that the long-term structural case for emerging markets remains intact.
Superior economic growth driven by favourable demographic trends and strong balance sheets means the centre of gravity of the global economy will continue to move towards the emerging world.
In the past 15 years or so emerging market real GDP growth has, on average, been 3.2 per cent higher than developed growth. According to the International Monetary Fund this premium growth rate is expected to continue for the next five years at least.
Furthermore emerging markets continue to account for approximately 60-65 per cent of global GDP growth. This is largely due to an acceleration of consumer spending and investment. In other words, it is a greater reliance on domestic consumption rather than simply exports to the west that is driving the growth.
So why is the MSCI Emerging Markets index down 6 per cent since the end of September 2010 when the MSCI World index is up 35 per cent (both in US dollars)?
The main reason for this is that even though a disaster was avoided as we emerged from the financial crisis, investors were pessimistic about the prospects for the developed world and optimistic about emerging markets.
Growth in emerging markets rebounded sharply in response to massive stimulus, but the developed recovery was, and remains, anaemic.
The problem is that after the initial recovery, the anaemic developed world recovery has actually been better than those very negative expectations and the growth rate in emerging markets has faded, particularly as China began to tighten in 2010. Growth surprises have been moving in opposite directions.
Emerging market earnings have also been relatively disappointing. Top-line revenue has fallen short of expectations and margins have been squeezed in the emerging world as costs, particularly wages, have increased.
A key reason for slower-than-expected growth in China has been the measures taken to rebalance the economy. It has been well documented that China needs to reduce dependence on fixed asset investment as a driver of growth and shift towards stronger consumption. The surprise has been that the new leadership appears to be pursuing this more aggressively than expected. As a result, demand for commodities has softened as new supply has coming onto the market.
Finally, comments from Ben Bernanke on May 22 suggesting that the Federal Reserve Bank could begin tapering its quantitative easing (QE) programme have negatively impacted those emerging countries reliant on short-term flows to fund large current account deficits.
In spite of a strong consensus that tapering would begin in September, this did not happen. Attention has now switched to December, but in the meantime emerging markets in general, and the countries with large current account deficits in particular, have rallied strongly.
This is just a short-term bounce and is not to be trusted. Near-term a number of headwinds remain. The structural problems in Europe are being addressed but issues could easily resurface. The withdrawal of QE has been delayed but not cancelled, and any aggressive unwinding of the significant emerging debt holdings built up by foreign investors could still be extremely disruptive for emerging equity markets.