The Grand Illusion; Global Investors Have Yet to Recognize the Turnaround in Developing Countries or to Price Emerging Markets Accordingly

Article excerpt

Byline: Ruchir Sharma (Sharma is co-head of global emerging markets at Morgan Stanley Investment Management.)

Just like the prisoners in Plato's cave--who, having never seen sunlight, believed the shadows on the wall were reality--global equity investors, too, have been dulled into mistaking perception for reality when it comes to emerging markets. Stock markets in developing countries are still widely viewed as highly risky assets. This perception is reinforced by high short-term volatility, as emerging markets fluctuate wildly in response to daily changes in the U.S. stock market. These tight short-term links obscure the long-term story, however, which is that emerging markets have outperformed equities in all other parts of the world, including the United States, since 1987--the year they started being tracked as an independent asset class.

A decade ago, it made more sense for emerging markets to rise and fall in tandem with the U.S. market. Back then, developing countries were reliant on global liquidity flows and an emerging market was defined as one that ran a large trade deficit, banked heavily on capital inflows and struggled to keep its currency from depreciating. Today that definition fits the U.S. economy almost perfectly. Meanwhile, emerging markets have metamorphosed, led by reform-minded leaders like Thaksin Shinawatra of Thailand, Luiz Inacio Lula da Silva of Brazil, and Recep Tayyip Erdogan of Turkey. Several major developing economies now run current-account surpluses, export capital and increasingly battle to keep their currencies from appreciating against the U.S. dollar. Yet global investors treat emerging markets as more closely tied to the United States than ever: daily price movements in emerging markets have a stunningly high 70 percent correlation with movements in the United States--almost double the level in the mid-1990s.

Partly this is because emerging stock markets are still largely driven by global portfolio flows, as they lack a strong culture of stock-market investing at home. And the fact that the world's largest economy has disproportionately contributed to global growth since the mid-1990s contributes to the U.S.-centricity. But even that's changing now. China on many measures is contributing as much as, if not more than, the United States to global demand, and there is evidence of greater regional integration within developing-country blocs, particularly in Asia, where the Chinese economy plays a dominant role. The combination of less dependence on U.S. growth and a turnaround in the balance of payments profile argues for reduced linkages between the stock markets of the United States and developing countries. …