Right now, when developing markets are flat on their backs, is the time for contrarian investors to look closely at them.
Thank goodness for emerging nations such as China, India and Brazil. By continuing to grow briskly, they kept the recession of 2007–09 and its immediate aftermath from turning into a global calamity.
Now, however, emerging economies are slipping. In India, for example, inflation is higher than in any other large country, yields on ten-year government bonds have jumped to nearly 10 percent, the rupee has lost two-fifths of its value, and growth in gross domestic product has dropped from about 9 percent to half that. China's growth rate is down by one-fourth, and Brazilian economists estimate that their nation's GDP will increase by a puny 2.9 percent in 2013.
Investors who rushed into emerging markets for protection from the economic storms at home are now heading out again. During the summer, individual investors pulled $18 billion out of emerging-markets bond funds as interest rates rose and prices plummeted, and little guys and institutions alike are fleeing stocks.
To borrow an old joke, emerging markets have become submerging markets. So far in 2013, even as U.S., European and Japanese stocks have climbed sharply, iShares MSCI Emerging Markets (EEM), an exchange-traded fund linked to a popular index for developing-market stocks, has lost 8.0 percent. Over the past three years, iShares S&P India Nifty 50 (INDY) lost 8.9 percent annualized. If you had put $10,000 into iShares MSCI Brazil Capped (EWZ) three years ago, your stake would be worth about $7,000 today; if you had put the same amount into Vanguard 500 Index (VFINX), which tracks shares of large U.S. firms, you would have $16,500 (all returns are as of September 6).
As a contrarian -- that is, someone who seeks out-of-favor investments -- all of this misery piques my interest. The best time to buy is when most investors are scared to death. Of course, you need to have confidence -- in this case, that submerging markets will reemerge. I do.
Emerging markets are highly volatile. Sharp ups and downs are in their DNA. Data compiled by Morningstar shows that emerging-markets stocks are about 50 percent riskier than U.S. stocks. Nothing goes straight up, but when stocks from developing nations come down, they usually fall hard.
Volatility is the price you pay for higher returns. If an investment produces the same return year after year (as, say, a Treasury note does), then the return is typically modest. Low risk, low return. But if you endure the sickening declines inherent in a high-risk investment, you tend to get a higher average return in the long run. There's no guarantee for the future, but over the past decade, the Brazil ETF returned an annualized 16.7 percent, and Vanguard 500 Index returned an average of 7.0 percent per year. Buy at a time like this, when emerging markets are suffering, and you have a better chance of winning in the end.
Emerging markets could, of course, be settling in for many years of decline. China's centralized control of the banking system, India's protectionism and Brazil's populism are certainly threats to economic growth. So is the new debt that both governments and businesses in such countries have issued in recent years, as lenders have stampeded to offer them cash. China's private-sector debt, for example, rose from 129 percent of the size of the economy in 2008 to 214 percent this June.
In my view, however, all of these economies -- and the governments that steward them -- are moving, in fits and starts, in the right direction, as are governments in Mexico, Indonesia, Malaysia, Chile and many other developing markets. In addition, businesses based in these countries are managed much better than they once were.
Also, emerging nations have advantages over developed countries. Most have plenty of young workers to support retirees, lack costly welfare systems that are difficult to reform and, despite recent increases in borrowing, carry low levels of government debt -- partly because after the defaults of the 1990s, lenders were reluctant for a time to extend credit. The ratio of total government debt to GDP in Brazil and India is 65 percent and 68 percent, respectively. In both China and Indonesia the figure is 23 percent. The debt-to-GDP ratio in the U.S. is 102 percent.
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