After a golden run, concerns are growing about inflation in emerging markerts, writes investment analyst Susan Easton.
Emerging market shares have had a dream run over the past decade.
While returns in developed economy markets like the United States, Europe and Japan have risen on average by 3 per cent per annum in US dollars over the past decade, emerging markets, such as China, Brazil, Russia and India have risen 14 per cent per annum over the same period.
Despite the increased risks that come with investing in these markets, 14 per cent a year has been a sumptuous return compared with the alternatives.
Sure, there were some speed wobbles in emerging markets at the height of the credit crisis when share prices plunged at least 60 per cent in US dollars terms in the space of a few months during 2008.
However, investor panic was short-lived as economic growth in these countries proved to be surprisingly resilient. They continued to attract external capital and were able to shore up economic growth despite the big fall-off in exports.
In contrast, the debt-laden developed economies were shrinking, some at an alarming pace, so it seemed an investment no-brainer to increase exposure to emerging markets. And as investors did so, it became a self-fulfilling phenomenon.
But past performance is no indicator of future performance. This year looks decidedly different to the pattern of outperforming emerging markets we've come to expect in recent years. In the year to date, the developed markets are up over 5 per cent in US dollar terms while emerging markets have fallen 2 per cent. That's a quantum of under-performance by the emerging markets that hasn't been seen since the credit crisis.
The divergence in market performance started in December last year but the trend has accelerated since mid-January. According to EFPR Global, investors pulled US$7 billion ($9.2 billion) out of emerging market funds during the last week of January, having pumped in US$95 billion during the whole of last year.
Whether it's a one-off or there will be continued large outflows and a prolonged period of poor relative performance, is an issue at the top of the agenda for global investors this year.
Ironically it's been the success of these emerging economies that is now causing the hiccup. There are growing concerns over inflation and monetary tightening, particularly in China, but now there are signs that those worries apply to other significant emerging economies as well.
The Chinese authorities have taken steps to rein in inflationary pressures by raising interest rates and tinkering with how much their banks can lend.
It's a delicate balancing act trying to maintain solid growth in jobs and incomes to keep workers happy while turning down the inflationary heat.
Furthermore, the property market looks a bit over-cooked and higher interest rates and a substantial tightening in lending criteria could easily send this important source of household confidence into a tailspin, and possibly the economy with it.
It's not just about what inflation has the potential to do to asset prices and equity returns but also whether basic food price increases might compromise political stability.
Food is a large component of consumer spending in the emerging economies and continued increases in food prices are a worry for households, politicians and markets.
Egypt has been the poster boy of late, showing, amongst other things, that fava bean prices have the potential to topple regimes. The bottleneck in global agricultural production strikes again.
At the same time as this has been happening, prospects in many of the developed economies, especially the United States, appear to be brighter. Indicators show economic activity is accelerating and the risk of a double dip recession has all but been eliminated. Even the European sovereign debt crisis of last year seems to be fading into the background - Portugal managed a reasonably successful bond auction in January.
Let's not forget the latest round of December quarter corporate profit releases out of the United States. These have been nothing but solid. Profit margins may be showing signs of peaking but companies are in good shape with overheads reduced, a bit of revenue growth and plenty of cash on the balance sheet.
Investor jitters will be centred on whether China (and a few others) can pull off the economic Houdini act of keeping inflation under control without undermining economic growth.
Despite the superior long-run GDP growth prospects for emerging economies, and their relatively low levels of household and government debt, investors may continue to pull money out of emerging markets until they are confident the authorities have inflation firmly under control.
Susan Easton is an investment analyst at Gareth Morgan Investment
