(By Mike) Ever since the acronym BRIC was coined by Goldman Sachs' Jim O'Neill in 2001, investors have been enjoying a decade-long love affair with emerging markets … although it's has been an on-again, off-again romance at times.
The economic, social and demographic trends underlying the emerging market boom have been well documented, so I won't repeat the details here.
But a funny thing happened along the way toward economic dominance for emerging markets: A global financial crisis.
Prior to 2008, emerging stock markets far outperformed most other asset classes around the world, and left U.S. stocks in the dust.
In the five years from 2004 through 2008, emerging markets soared 189 percent … outperforming the Dow Jones Industrial Average nearly 5-to-1!
In the immediate aftermath of the financial crisis, emerging markets also snapped back quickest — up 68 percent in 2009, more than twice the return from U.S. stocks.
Alas, starting in 2010 emerging markets lost their upside momentum compared to U.S. stocks. And they have continued to struggle since. Through the end of last week, the Dow was up 26.6 percent over the past 12 months, while the MSCI Emerging Market Index gained just 2.6 percent.
But so far this year we've witnessed a reversal of fortune for emerging market stocks with performance improving dramatically (up 9 percent year-to-date) and running virtually neck-and-neck with U.S. stocks (+9.8 percent).
There are several fundamental factors underlying this reversal of fortune … and they bode well for further potential gains ahead. Let's take a closer look …
Rising Tide of Money
Lifts EM Stocks Again
Stocks, bonds and other asset prices follow the money flows in global markets — ultimately flowing into assets that appear most attractive from a return/risk point of view.
Simply stated, money flows to where it is treated best!
After the 2008 financial crisis, and with every flare up in financial stress we've witnessed since, money flowed out of emerging markets and other asset classes like commodities. Instead, global cash poured into assets perceived to be "safe havens" in times of turmoil, such as the U.S. dollar, and Treasury bills and bonds that are thought to be risk-free investments.
This year however, the dynamic has reversed (see above chart) with outflows from emerging markets slowing sharply … and by the end of June they had become positive net capital inflows once again.
This is indeed a sign that risk-aversion has diminished to the point where global investors are taking advantage of attractive buying opportunities in emerging markets.
And why not?
After all, most developing nations still have much stronger economic growth potential, as well as balanced budgets and fiscal policies that are generally more responsible.
Recently, the International Monetary Fund (IMF) cut its forecast for global GDP growth primarily due to the fiasco in Europe. They now expect advanced economies (U.S., EU, Japan) to expand just 1.4 percent in 2012 … and a still anemic 1.9 percent in 2013.
By contrast, emerging market economies are expected to grow 5.6 percent this year, accelerating to nearly 6 percent GDP growth in 2013!
Granted, this is less than the growth rate investors are used to seeing from emerging markets. But remember, global investing is a relative game. Emerging markets take the gold medal in growth compared to U.S. GDP of just 1.5 percent last quarter, or the EU, which — no surprise — sank even deeper into recession last quarter.
Take a look at valuations and you'll see that not only are growth prospects better, but emerging stock markets look like a relative bargain compared to developed markets.
You might think with European stocks hit so hard this year they might be cheap, but think again:
While some individual country stock markets in the EU look attractive, the Bloomberg European 500 Index as a whole sports a rather rich price-to-earnings ratio (P/E) of 16.6 times this year's estimated earnings. And with the EU recession deepening, profit estimates may be falling and the P/E rising before long.
In the U.S., the S&P 500 Index is valued at a more attractive P/E of 14.3. But concerns about profit growth in the third- and fourth-quarter are also on the rise here at home.
The MSCI Emerging Market Index looks dirt-cheap by comparison with a P/E ratio of just 11.8 — well below its long-run average of 16.4 since 1989! And as pointed out above, this bargain valuation is combined with stronger economic and profit growth potential.
Bottom line: Money is being treated to better long-term profit opportunities in emerging markets. So it's no surprise investors are responding with stepped up money flows into stocks, bonds and other assets in the region.
Emerging market bond funds, for instance, have taken in more than $46 billion so far this year according to Bloomberg. That's already more than the $43 billion of total inflows for all of 2011 with five months still to go.
And if the recent surge in emerging market equity ETFs is any indication, and I believe it is, we may only be in the early innings of the next phase of long-term outperformance for emerging market stocks. Stay tuned!
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