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Emerging Markets Offer Little but Higher Risk in Recent Years

K.C. Swanson

Emerging markets, which held up fairly well the last time the U.S. economy lagged, are faltering now. Their slowdown, which mirrors slumps in the U.S. and developed markets, shows how few options exist for investors seeking growth outside the U.S.

That's a big change from the early '90s, when emerging markets offered a way for investors to diversify as the U.S. struggled with a recession. Markets in places like Southeast Asia, for example, were just opening to outside investors. During some years, the emerging markets generated returns far greater than those in the U.S. The Morgan Stanley Capital International (MSCI) emerging markets free index gained close to 60% in 1991 and 75% in 1993.

Four years after the Asian financial crisis another U.S. recession looms, but the performance of emerging markets remains lackluster. While countries like Korea have staged brief comebacks, most developing economies have failed to gain traction. And emerging-markets bulls are few and far between.

"Historically, people saw international diversification as beneficial in reducing risk and increasing returns," says Paul Matthews, chairman of Matthews Funds, which focuses on Asian investments. For investors in emerging markets, "clearly there's a perception [now] that the risks are higher and the returns don't justify the risk."

In line with that perception, investments in the area have become stingy at best. Since the financial crisis, investments in emerging markets have dropped off sharply from levels earlier in the decade. Since the beginning of the year, emerging-markets funds saw negative flows of $0.17 billion through August.

Why Investors Lost Interest

Despite the early promises of high growth by analysts, the long-term performance of emerging markets has been unimpressive. Measured in U.S. dollars, the MSCI emerging markets free index averaged a 0.10% loss over the past 10 years. In contrast, the MSCI U.S. index averaged annual returns of 10.6%.

That is partly because the U.S. saw higher sustained growth rates over the past decade than emerging markets. "It did seem like the only country with a marked increase in underlying average growth rates was the U.S.," says George von Furstenberg, a finance professor at Fordham University and former International Monetary Fund division chief.

As the '90s progressed, emerging markets became vulnerable to changes in investor sentiment in the U.S. and Europe. The volatility of stocks in emerging markets greatly increased as speculative foreign money poured in. If major investment houses in London or New York reduced their exposure to emerging markets, stock markets in places like Thailand or Malaysia could take serious hits.

At the same time, developing countries became increasingly tied to the international supply chain with factories that assemble electronic and clothing goods. As a result, the economic fortunes of developing countries became more closely aligned with those of the U.S. In fact, as home to many contract manufacturers, some countries in Southeast Asia may feel the effects of a slowdown sooner than the U.S.

It's no surprise, then, that emerging markets have recently performed worse than the domestic market. Measured in U.S. dollars, the MSCI emerging markets free index was down 24.69% from the beginning of the year through Sept. 28, compared with a loss of 20.80% for the MSCI U.S. index during the same period.

In addition, investors in emerging markets must now contend with another external shock: fallout from the recent terrorist attacks. "Here we have an open-ended problem with ramifications we will not know about for years. It's the kind of thing that makes investors extremely liquidity conscious," says Von Furstenburg. "And if there is a flight to liquidity, they want to hold investments in the hardest currencies in the prime markets."

The Outlook for Emerging Markets

That's not to say investors will entirely give up on emerging markets. But they may define them more strictly. "I've always questioned whether the emerging-markets concept made a lot of sense," says Matthews. "Over the years that definition has included poor countries with newly open stock markets, rather than developing countries."

Instead, investors should focus on growing economies rather than emerging markets, Matthews adds.

Case in point: For some time, investors have been awaiting the chance to invest directly in China, which will need to ease its capital controls as part of joining the World Trade Organization. Though Asian economies and markets have been volatile for the past few years, says Matthews, "I have no doubt they will continue to grow faster than the U.S. in the long term. And a lot of that is based on the belief that China will continue to be one of the fastest-growing economies in the world."