Not long ago, the emerging markets of Brazil, Russia, India and China were saturated with investors, but the global economic downturn caused many to flee as fast as they had once rushed in. Some analysts, however, say the pendulum may swing back in their favour. Harvey Jones reports
The emerging-markets story has been a cracker. A real page-turner, one that has kept investors riveted for the past decade. But is it now coming to an end - and if so, will it have a happy ending?
A decade ago, there was no such thing as BRIC. Now we can all name them as Brazil, Russia, India and China, the sleeping global economic giants that have finally been roused from their slumbers.
China has been registering GDP growth of about 10 per cent a year for a decade. It recently overtook Japan as the world's second-biggest economy, and looks on course to overtake the US as early as 2020.
India boasts a billion people and a middle class running into the hundreds of millions, and has transformed itself into the back office of the world. Natural resources giants Brazil and Russia have also stirred into life.
As debt-addled developed countries summoned a banking crisis onto their heads, the BRICs surprised everybody by decoupling from the West and continued to power on at breakneck pace.
The story reached its climax at the end of last year, when the US Federal Reserve fired up another US$600 billion (Dh2.2 trillion) of quantitative easing, and the hot dollars flowed straight into emerging markets.
Then came a shock twist. Investors started to flee emerging markets and sought safety in the developed world instead, says Spencer Lodge, the Dubai-based managing director at the financial brokerage PIC deVere. "Since October, emerging markets have underperformed the West by almost 10 per cent."
So is this the end of the emerging markets story, or the start of a new chapter?
Investors have been scared by rising inflation in China and India, which are desperately trying to cool their overheating economies by splashing them with interest rate hikes. Investors shivered and looked elsewhere. "They warmed to the US, with its attractive blend of ultra-loose monetary policy and strong economic recovery," Mr Lodge says.
As recently as January, 43 per cent of fund managers were still overweight in global emerging markets equities, according to a monthly Bank of America survey. In February, that figure plummeted to just 5 per cent, the steepest reversal recorded.
India was the first in the BRIC to crack. Bombay's Sensex index plunged more than 10 per cent in February, as foreign investors withdrew more than $1.5bn. Brazil is down 4 per cent so far this year and China has flatlined. In February, the export powerhouse posted a shocking trade deficit of $7.3bn, its largest in eight years, with both imports and exports lower than expected.
Trouble in the Middle East hasn't helped. Emerging markets are particularly vulnerable to an oil shock because they have a greater oil intensity than the more efficient West, which mean they consume more oil to produce each unit of GDP.
While oil use in places such as the US, Europe, Japan and Australia is set to decline, according to the International Energy Agency, Chinese oil demand is expected to grow to 14.3 million barrels a day by 2030, up from 8.1 million in 2009. It is no coincidence that Russia, a major oil producer, is the only BRIC whose market has held its own this year, rising 9 per cent mostly the result of the oil price spike.
This isn't a crash landing, Mr Lodge says. Investors may have pulled out billions of dollars, but this amounts to just 2 per cent of assets under management. "Most analysts expect further downside over the next several months, but this could ultimately prove a tactical buying opportunity," Mr Lodge says.
If you're thinking of pulling your own money out of emerging markets, forget it: you've left it too late, says Jeremy Batstone-Carr, the head of investment research at the London stockbroker Charles Stanley. "The time to pull out of emerging markets was at the end of last year, when everybody else was pulling out. Now markets have fallen, you have smaller profits to protect."
But investors who have fled emerging markets for Europe could quickly regret their decision, he says. "The European Central Bank is likely to follow emerging markets by pushing up interest rates, despite the mounting problems faced by euro zone countries such as Greece, Ireland, Portugal and Spain. This could easily backfire and cause massive problems."
Mr Batstone-Carr says the wise investor should be counter intuitive right now. "As money flies out of emerging markets, it might be time to start thinking about going back in, although I wouldn't jump in with both feet just yet."
One drawback to investing in China is that the big companies are owned by the state, and the interests of foreign investors come low on their list of priorities. Many smaller companies have been found guilty of fiddling their books.
Rather than investing directly in emerging market companies, investors could reduce their risk by targeting established western companies with exposure to the region.
"Pharmaceutical companies AstraZeneca, Glaxo and SmithKline are all expanding into emerging markets," Mr Batstone-Carr says. "Scottish engineer Weir Group earns nearly 40 per cent of its revenues from emerging markets and may also benefit from the rising oil price through its oil and gas-shale drilling business. Food group Unilever earns 50 per cent of its profits overseas, although it is in a very competitive market."
Others fear the current emerging market reversal is more than a blip, but points to deep-rooted problems. The China growth story has been extraordinary, but that in itself could be cause for concern, says Stuart Fowler, the founder of No Monkey Business, a London-based investment manager.
"The better the story, the more likely it will lead to a stock-market bubble," Mr Fowler says. "I believe the China bubble actually burst in 2006 and valuations are still catching up with reality. It could be a long time before the China story leads to competitive returns for investors."
Indian company profits have been bolstered by protectionism, but this can't go on forever. "They aren't exposed to the full force of competition, but at some point they will have to open up. When this happens, it will expose Indian share valuations as excessive," Mr Fowler says.
The price-to-earnings ratio is a handy rule of thumb for whether a stock market is overvalued. It measures the value of a share or market, divided by its earnings. Any score around 15 is thought to indicate fair value.
At the time of writing, China's price-to-earnings ratio stood at a reasonable 13.7, Brazil looked marginally better value at 13 times earnings, while Russia looked relatively cheap at 10.3. India, however, looked pricey at 20.5, and that's despite recent falls. By comparison, the UK was trading at 15.3 and the US at 16.9.
The price-to-earnings ratio isn't everything, of course. Russia's unfortunate reputation for corruption and political meddling partly explains why its markets trade at a discount, says Dan Dowding, the chief executive of IFAs Killik & Co in Dubai. "But Russia still looks cheap relative to India, and you can't ignore its significant oil and gas reserves."
There is a strong and simple case for investing in Russia. "Developed and emerging economies all need oil and gas, and Russia can supply it. This gives the country a major advantage over China and India, which are both net oil importers. My favourite fund in this region is Neptune Russia and Greater Russia, managed by Robin Geffen."
Mr Dowding says emerging markets have partly become victims of their own success. Investors and fund managers have found themselves overweight in these markets precisely because they have performed so well, and many are simply balancing their portfolios to avoid becoming over exposed. "You can still play the emerging markets growth theme by investing in western companies with a global reach, many of which are now cheaper than their emerging market counterparts, including Volkswagen, BMW, PepsiCo, BASF, Yum Brands, BG Group, BHP Billiton, LVMH, Burberry and Mulberry."
So what about Brazil? With China as its major trading partner, the Latin American giant is vulnerable to a Chinese slowdown, Mr Dowding says. "But it does have plenty of natural resources, plus the World Cup in 2014 and the Olympics in 2016. This will lead to massive investment in infrastructure and a boosting domestic demand, so any weakness in this market could be a buying opportunity."
Brazil has a healthy future ahead of it, says Nick Robinson, the London-based head of Brazilian equities at Aberdeen Asset Management. "A more stable democratic process, vast natural resources, more orthodox economic policies, a youthful population with rising earning and spending power, and a growing pool of well-managed companies make this a good place to invest."
Like every global investment story, emerging markets will have plenty of plot twists and swings. But the story will change. Emerging markets such as China have risen to power on the back of cheap exports and undervalued currencies. But this can't last forever. At some point, they have to boost domestic consumption and redress global trade imbalances.
China's new five-year plan appears to be heading in this direction, by focusing on improving local incomes and living standards, boosting energy efficiency and securing sustainable growth. GDP growth is no longer everything.
Perhaps this does mark the end of the first chapter of the emerging markets growth story. If so, the current pause promises to be a great opportunity before the narrative picks up speed again. The next chapter may not be quite so dramatic, but nobody thinks the story is over for good.