It is “inconceivable” that emerging markets will repeat their stellar absolute and relative returns of the 2000s in the future, according to Neptune’s James Dowey, who says investors buying in now in the hope of a re-run of that performance need to realise the period was a bubble like the tech and housing booms of recent times. 
Having been very out of favour over the past five or so years due to China’s slowing growth, falling commodity prices and a strong US dollar, many believe that 2016 will usher in the start of emerging market outperformance relative to the likes of the US, UK and Europe which are trading at or above their historical average valuations.
The consensual view is that while the developing world has certainly had its issues over the past half a decade, funds which focus on emerging market equities offer investors a far higher return than those geared towards the likes of Europe or the US due to the higher levels of economic growth on offer and increasingly wealthy middle classes.
Performance of indices over 5yrs
Source: FE Analytics
To back up their point, many advocates of this view highlight the performance of emerging markets relative to developed markets during the 2000s – whereby the average IA Global Emerging Markets fund beat the MSCI World index by some 155 percentage points.
Though Dowey – who is chief economist and chief investment officer at Neptune – advocates upping exposure to emerging markets thanks to low valuations, a more global thinking US Federal Reserve and signs of stabilisation in China, he says investors cannot expect those sort of relative and absolute returns to be repeated ever again.
“My view is that it is almost inconceivable that we return to the types of outperformance that we saw during the 2000s in emerging markets. We need to be very strongly cognisant of that,” Dowey (pictured) said.
Dowey says the period was unusual in a number of ways.
“We have had an extraordinary period where emerging markets completely blew the lights out in the decade of the 2000s. At the same time, the West was stumbling headlong out of the tech bubble straight into the sub-prime crisis which only accentuated the sense that it was the right thing to do to buy emerging markets.”
“Take the US for example during that decade: prior to that episode there are only three historical periods since 1870 during which the S&P failed to produce a positive real return over 10 years – the First World War, the Great Depression and the 1970s’ stagflation.”
“This was a very serious and unusual period. At the same time, if you take an equally-weighted index of the four BRIC markets during the 2000s, you got a return of 370 per cent.”
Performance of indices during the 2000s
Source: FE Analytics
To explain his view, Dowey highlights the views of Nobel prize-winning economist Robert Shiller and his writings on behavioural finance.
“What Shiller emphasises is that when you have extraordinarily high returns in an asset class there is a positive feed-back mechanism that occurs between those abnormally high returns and exaggerated stories about fundamentals,” Dowey explained.
“What happens within this dynamic is that it subjects investors to confirmation bias, so you believe the story and the market is going up because of the story – and that makes you believe the story even more.”
For example, Shiller described tech and housing bubbles in that way and Dowey says that is how investors should view the significant absolute and relative returns of emerging markets during the 2000s.
He says there were two exaggerated claims about fundamentals in emerging markets that helped fuel the bubble – one economic and the other political.
The economic claim centred around the idea of ‘unconditional convergence’, the view that poorer countries will always generate higher growth levels than rich ones. The political claim comes from Francis Fukuyama’s journal ‘The End of History’ following the collapse of the Soviet Union – the belief that emerging economies were on the road to liberal democracy.
However, Dowey notes that there was a huge amount of confirmation bias at the time as investors only centred on economic growth in the BRICs (Brazil, Russia, India and China) rather than the poor growth in other emerging economies. On top of that, most of the BRIC nations have had significant political issues to deal with in recent years.
Dowey added: “The point I’d make here, and this is value of thinking about this issue in Robert Shiller’s terms, is that there is a momentum required in this feedback mechanism. The stories need to hold in place and they have been decimated.”
“Growth has disappointed over the past five years, the market has underperformed really quite dramatically, the politics has looked awful – this mechanism lies in tatters today.”
That being said, Dowey is still relatively bullish on emerging markets relative to developed markets.
Neptune started adding back to emerging markets around February time. The likes of Robin Geffen, manager of the group’s global funds, have long-viewed developing world equities as cheap but until recently saw no real catalyst for those low valuations to rise.
However, as the US Federal Reserve has had to think more globally about the impact further interest rates will have (and therefore curbing the chances of significant dollar strength from here) and with signs of stabilisation in China (aided by further stimulus) means Geffen has been buying into the market again – a call that has so far paid off.
Performance of indices since February
Source: FE Analytics
Dowey added: “With these two risks, in our perception, being much smaller than they were at the start of the year, we have warmed to emerging markets.”