Oracle: Remember the rules of the road

Kerry Craig

‘It’s the land of the future, and always will be.” I think of this joke every time I hear someone explain why the future belongs to the emerging market economies, and why I should park a big chunk of money in a fund marked “EM”.

Fans of emerging markets have had a tough few years, but the unexpectedly decent performance of emerging market stocks and bonds this year has many proclaiming that now is the time to take the plunge.

The main MSCI emerging market stock index has risen by more than 8 per cent since the start of 2014, smashing the 3 per cent rise in the FTSE.

Now could be the time to start investing in emerging markets. But bear in mind some rules of the road.

First, don’t expect them to shed their “emerging” status any time soon. A recent World Bank study looked at the 101 countries considered “emerging” in 1960; by 2008, only 13 had graduated to the “advanced” economy category.

One of JPMorgan’s emerging market fund managers keeps an old copy of The Times’ share listings as a reminder of how long it has taken for most countries in the world to “emerge”. The countries on offer are similar to today. Only the date is different: 1825.

Second, don’t assume that strong economic growth will automatically translate into high returns. Take China: its economy has more than doubled in cash terms since 2007, but its stock market is 22 per cent lower than it was before the financial crisis.

Economic growth is helpful, but emerging market stockmarkets are often relatively small relative to the size of their economies – precisely because they are emerging market economies – and heavily distorted. There’s no guarantee that growth in the country at large will benefit investors.

So, if you can’t bank on a bright future for emerging market economies or on growth translating into higher returns, why invest?

In the long term, emerging markets can deliver better returns than mature ones. Over the past 10 years, the MSCI emerging market index has delivered an average total return of 11.4 per cent a year – higher than the return on the UK, the US or continental Europe.

Third, buy cheap by investing before everyone thinks it’s a good idea. Optimism can push people into investing when the price is relatively high. While that sometimes makes sense, the higher the price you pay, the less downside protection you have if the long-term growth story goes awry.

In January 2010, emerging market stocks were expensive relative to their long-term average, with a price-to-book ratio around 19 per cent above the long-term average. UK stocks, meanwhile, were trading at a discount, with a price-to-book ratio around 10 per cent below the long-term average.

Those valuations make economic sense, given that the UK was flat on its back while India, China and other emerging markets were roaring ahead. Any fund manager trying to persuade clients to invest in the UK or Europe had a tough time, while the investor dollars were piling into emerging markets.