From the June 2011 issue of Investment Advisor • Subscribe!

Emerging and Developed Markets—Decoupling or a Reversion to the Mean?

Vast differences in economic growth rates are at work in the performance disparity between developed and emerging markets

Global equity markets have recovered strongly following the financial crisis and recession. Large-cap developed market indices, such as the S&P 500 and the MSCI EAFE, generated gains of 91.2% and 90.8%, respectively, from their lows in March 2009 through the end of 2010. But those strong results were dwarfed by the incredible rebound in emerging market equities; the MSCI Emerging Markets Index surged more than 146% in the same period, leading many investors and analysts to believe that they were witnessing a decoupling of these markets.

Why the huge performance disparity? It can be attributed, in large part, to the fact that economic growth rates in emerging markets have far outpaced the anemic growth rates we’ve seen in developed markets. For example, China, India and Brazil experienced GDP growth of 20%, 18% and 7%, respectively, from the end of 2008 through the end of 2010. During the same period, U.S., U.K. and German economies logged growth rates of 2%, 0.70% and 1.30%, respectively.

While economic growth rates in emerging markets are still well above rates in developed markets, equity indices took decidedly different directions at the start of 2011. Through March 9, 2011, the MSCI EAFE and S&P 500 were in positive territory with gains of 4.80% and 5.40%, respectively. The MSCI Emerging Markets Index, on the other hand, lost just over 1%. The dispersion was even stronger earlier in the year; at one point in late February, developed indices were ahead of the emerging markets index by almost 10%.

If emerging market economies are so much stronger than developed market economies right now, why have their equity markets underperformed?

Dissecting the Diversion in Returns

Several factors have contributed to the drop in emerging market equities and to the relative strength in developed markets. One of the most obvious explanations can be seen in fund flows for the first two months of the year. Through the end of February, emerging markets saw outflows of $6.7 billion, the most of the 89 categories tracked by Morningstar. On the other hand, large-cap developed markets took in more than $25 billion.

Some of these directional flows can be attributed to beginning-of-the-year portfolio rebalancing. In addition, profit taking in emerging markets was surely at work as investors sought to lock in gains after a run of such strong performance. Moreover, many investors may have decided to decrease exposure to emerging markets or to increase exposure to developed markets because of relative valuations.

Due to their higher risk, emerging markets have historically traded at a discount to developed markets on a P/E basis. At the end of 2010, however, the MSCI EAFE and Emerging Markets indexes were trading at almost the same valuation—a rare occurrence.

While these factors surely have contributed to the reversal in performance trends, the key catalyst appears to be the jump in commodity prices and inflation figures as the global economy has continued to recover. Accelerating inflation has significant yet different implications for developed and emerging markets. Based on market reactions, the emergence of inflation has been viewed as a positive for developed markets, but as a negative for emerging economies. And that disparity is directly related to what has driven performance off the bottom—the vast differences in economic growth rates.

In the July issue of Investment Advisor, McAllister will expand on inflation’s impact on the global economy, and share his view on emerging markets trends.

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