Why the BRICs will fall

9th May 2012

And some are looking further afield, to so-called frontier markets, as well. Africa fans have been heartened by Tullow Oil's Kenyan activity even if this was just days after disappointing news from its Ghanain exploration.

But just as some companies are looking to reshore production, it could be time for investors to consider the reverse BRIC argument: developed markets good, emerging markets (whatever their acronym) past their sell-by date.

As the BRIC formulation enters its second decade, even the investment non-savvy can recite the reasons for plunging into their stock markets of countries.  Almost anyone can quote export-led expansion, cheap labour, less debt, lower dependency on state-provided services such as health and education, banks with little exposure to problems, fast-growing consuming classes, and increasing populations.  The last two do not apply to Russia but it has mineral and oil wealth to compensate.

China takes on the US

And it is impossible to ignore that China is poised to overtake the United States in all manner of economic indicators although as China has five times the American population, this is never quoted on a per head basis. The people of Denmark, for instance, do not worry that their gross domestic product is well behind the United States as they know they are, on average, better off.  In any case, Chinese exports fell their fastest for over three years in the first quarter of 2012 while its manufacturing growth is at the lowest level for well over a decade.

Assuming, however, that these Chinese figures are blips and that all the economic factors applied to emerging markets turn out to be as benign and optimistic as their proponents expect, this does not add up to stock market success. Germany has been an economic powerhouse for decades. Its companies are profitable, dominating sectors. Yet its DAX equity market index stands at just under 6,500 – it topped 7,000 twelve years ago. And during the post-war years of the West German economic miracle, stock markets were largely moribund.

Germany's non-miracle market

The investor lesson is that wealth in an economy does not necessarily translate into profits for shareholders. In the German case, rebuilding a war-shattered nation, paying high salaries to staff rather than just the boardroom, and a low risk domestic model based on bonds rather than equities all helped bring about a lacklustre equity market.

On Reuters, blogger Scott Barber asks whether emerging market equities should trade at a premium. They don't. As he points out: "Emerging markets have faster growth, lower debts and better demographics than developed countries. Historically, investors have placed a higher multiple on developed markets – this may have been justified when developing countries seemed more likely to hit a crisis. Now that this has reversed shouldn't these countries be more highly valued?"

Greed and corruption

There may be all sorts of reasons why they don't – corporate governance, reputation, corruption, dividend levels, distribution of profits, taxation are just some of the possibilities. There is no clear correlation between stock market and economic performance.

Valuation parameters and growth are not synonymous. A market valued on a price/earnings ratio of 10 could double in profitability and price and so still be on the same p/e. A market on 20 could go nowhere but still be more highly valued.

Measured by UK fund performance – admittedly not the most perfect metric given the ability to slice and dice through the stats, the strengths and frailties of individual managers and currency issues – global emerging markets have hardly been investment superstars.

UK funds beat the emerging markets

Trustnet shows the average IMA Global Emerging market fund gained 39.7 per cent over the past three years while the typical Global (developed market) fund gained 31.7 per cent. It is an appreciable gap but is it wide enough to embrace countries which are growing at such a pace?  The IMA UK All Companies three year average beat both – at 42.4 per cent. Perhaps the UK was a secret emerging market?

More probably, this could reflect higher fund management skills on average in the home stock market. For all equity markets come down to stock selection – even passive investors have to make do with the stocks in an index which have that position because others have bought into them, propelling them into the top 100 or 250, for instance.  Fast growing economies have their duds while go-nowhere nations  have corporate superstars.

Developed markets developing well

Still, with the eurozone in turmoil and the UK enmeshed, willingly or not, it may take a leap of investor faith to back established markets. Johanna Kyrklund, Head of Multi-Asset Investments at Schroders points out that investors wanting to add risk  back to portfolios – perhaps because they see little future in bonds – should do so through a mix of developed market equities and cash rather than other assets such as bonds which might be on the expensive side.

She says: "With events in Europe casting a shadow over the global economic outlook, investors should be looking for assets which have a valuation cushion, and which are liquid. Emerging market currencies are vulnerable to a growth slowdown in China.

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