Emerging market equities certainly had given investors a great ride for a long time. During the 10-year stretch to the close of 2010, these investments as a group returned almost 18% a year, according to the MSCI Index. That's a 17.5 percentage point annual premium over the S&P 500.
The difference was similar against European and Japanese indices as well. And that enviable performance was pretty widespread among emerging markets. Of the popular BRIC economies—Brazil, Russia, India, and China—Brazil's IBOV stock index rose at approximately a 20% annual pace during this long stretch, Russia's MICEX stock index rose at approximately a 24% annual pace, India's Sensex index at above a 19% pace, and China's Shanghai index by approximately 3% a year.
Against such a brilliant background, it is easy to understand the sudden loss of enthusiasm brought by underperformance during the last 12 months, especially in the popular BRIC markets. America's S&P 500 Stock Price Index, uneven as its performance has been, has beaten three of these four. In comparison to the S&P 500's 11% gain during this time, Brazil's Bovespa Stock Index fell 15% and India's index fell 6.5%. China's market showed no net movement. Only Russian stocks have outperformed America's, rising about 9% during this 12-month span.
Other emerging markets, less popular since the BRIC concept needlessly narrowed investor focuses, have done better. The 17% to 19% gain recorded for the MSCI Emerging Markets Stock Index during the past 12 months occurred despite the significant drag exerted by the heavy weight of the BRICs in the aggregate. Clearly, other less favored smaller markets outperformed significantly.
Of course, even during the salad days of the 2000-2010 decade, these markets registered occasional shortfalls. They have always been more volatile and have at times suffered dramatic setbacks. But this more recent setback looks different from this past and has troubled investors because of two additional considerations. One is valuation. These at last have risen to levels comparable to developed markets. In doing so, they have elicited concerns over future pricing and market gains. The other has to do with economic fundamentals, most especially the inflationary pressures that have begun to plague these economies and their likely adverse effect on growth.
The valuation issue reflects directly back on the great gains of the past. Most analysts recognize that more than half the remarkable emerging market equity returns of the last 10 to 20 years occurred because valuations could ratchet up from initially very low levels, first as surface fears of the unknown dissipated, then as these economies proved themselves more reliable, and finally, as their policies proved themselves more responsible. Some calculate that as much as three quarters of emerging market gains during this 10-year stretch occurred because of this valuation shift. Now that many emerging market valuations equal those of developed markets, investors legitimately conclude that this source of gain has likely played itself out.
Especially in light of the valuation question, concerns about recent inflationary pressures and other economic problems weigh that much heavier than they might. There certainly is no question that these economies face serious challenges. Inflation stands front and center. China's inflation at last measure shows an annualized rate of more than 6%. India's has come in closer to 9%, and Brazil's has broken a 6% annualized rate. The governments in these economies have responded with monetary restraints of various kinds that, though an appropriate response, threaten growth prospects. More, the appearance of such problems has shaken a former, firm confidence that these economies could avoid such infirmities.
Certainly, policymakers in these economies have sought to restrain growth. The People's Bank of China has over the past year increased its benchmark interest rate five times by over 125 basis points to 6.56%. It also has steadily removed liquidity from its financial system by raising the reserves Chinese banks must hold against deposits. In six moves, the People's Bank has brought this ratio up to a remarkable 21.5%. At least as aggressive in its own setting, the Reserve Bank of India shocked markets recently by raising its benchmark lending rate 50 basis points to 7.25%. Adding to the pressure, it warned markets of more to come. Brazil has raised its Selic benchmark rate five times so far this year to 12.5% at present. With the central bank promising more, consensus opinion now conservatively expects a 12.75% rate by year end and possibly higher. Russia, which has less of an inflation problem and so presumably has less need for restraint, is facing it anyway, not from policy but from capital outflows that approach an $80 billion annual rate, enough to more than offset any inflows from increased oil revenues.