Emerging Markets Drag Investors Back Into Hole

Americans have $22 billion invested in emerging-markets stock mutual funds. Based on the sector’s performance of the last decade, it’s a wonder there’s even a dime left there.

In the 10 years through 2000, the average total return on emerging-markets funds tracked by Morningstar Inc. amounted to just 2% a year.

That compares with a 17.4% average annual return on the blue-chip U.S. Standard & Poor’s 500 index in the same period.

Even allowing that the U.S. market’s gains in the last decade were absurdly high, and that returns this decade seem destined to be far lower, the history of emerging-markets investing hardly engenders confidence that you’ll do better there than here over an extended period.

An emerging market, by definition, is a place where the investing risks are high--Argentina, for example. Things are supposed to go wrong periodically in high-risk markets. But classic investment theory says you’re supposed to be amply compensated in the long run for taking higher risk.

It has worked that way in the U.S. corporate junk bond market. Over the last 10 years, the total return on an index of junk bond mutual funds tracked by Lipper Inc. has been 119%, versus 90% on an index of U.S. government bond funds.

But in the case of emerging markets, above-average risk has equated with below-average returns in the last decade.

Argentina’s latest financial crisis must sound all too familiar to investors who have been paying attention to emerging markets for more than a few weeks.

Latin American nations, whose securities have typically accounted for a large share of the assets of emerging-market funds, have suffered through a series of financial crises since the early 1980s.

After a borrowing binge in the 1970s, Mexico in 1982 found itself deep in debt and unable to secure new financing after it nationalized its banks. That set off the Third World debt crisis of that era, which resulted in tortuous debt restructurings for many emerging-market countries that had borrowed aggressively in the ‘70s.

Despite the global economic boom of the late ‘80s Latin America’s outlook remained bleak. Hyperinflation gripped the region into the early ‘90s, making it largely unappealing to global investors.

By 1990, Mexico was restructuring its debt yet again as part of far-reaching economic reforms. And in 1991, Argentina’s economy minister, Domingo Cavallo, took the daring step of tying the country’s currency (the peso) 1-for-1 to U.S. dollars held in reserve. The idea was to restore confidence in the peso and eradicate the hyperinflation mind-set that led people to eschew long-term investing.

It worked for Argentina. And by 1993 much of Latin America was believed to be on the mend. Even the old line about Brazil--”Brazil is the country of the future, and always will be”--seemed no longer valid.

In 1993, emerging markets in Latin America and East Asia enjoyed a spectacular rally that sent the average emerging-markets stock fund up 73.3%. It was hailed as the start of a new era.

Instead, it proved to be a flash in the pan. The Federal Reserve began raising interest rates in 1994 to slow the U.S. economy, and the spillover effect hit emerging markets hard. The bigger shock came in December of that year, when Mexico tried a controlled devaluation of its peso that turned into a rout as investors fled the country’s securities.

By 1997 it was East Asia’s turn. A currency devaluation in Thailand spread like wildfire throughout the region, devastating financial markets. The crisis jumped to Russia in 1998 and to Brazil in early 1999.

Now, after a decade of supposed progress, it’s Argentina that is in trouble again. And debt, once again, is the heart of the problem.

Though its economy has been in recession for much of the last three years, Argentina’s government has continued to pile on debt to make up for tax-receipt shortages. Total debt now is just under $130 billion. The government has been enabled in part by yield-hungry foreigners willing to extend credit (via bonds) at high rates. That is both the upside and the downside of the ease with which capital now moves across borders in the global economy.

But many bond investors no longer believe Argentina can pay its bills. Last week, those investors demanded record-high yields of 14% on three-month treasury bills the government issued. Argentina knows it can’t borrow at those rates for long. The message from the market is, “Get your fiscal house in order.”

Investors fear that will lead Argentina down the same road as Mexico in 1994 and East Asia in 1997: a currency devaluation.

A devaluation is financial markets’ way of saying that the whole of a country’s wealth is worth less--sometimes far less--than what its citizens and businesses had believed.

Devaluation slashes a nation’s purchasing power. In 1994 in Mexico, it took 3 pesos to buy one U.S. dollar. After the country’s devaluation, it took 6 pesos to buy a buck. The average Mexican’s purchasing power thus was cut in half.

Likewise, a devaluation instantly reduces the value of foreign investors’ assets in a country when translated back into their own currencies. A Mexican stock trading for 3 pesos was worth $1 before the country’s devaluation. Afterward, the same stock was worth just 50 cents to a U.S. investor.

For that reason, investors naturally would prefer to flee a country’s assets before a devaluation occurs--a big problem for Argentina now.

Why, then, do countries devalue? Often, they have little choice; free markets force the issue. A currency generally (though not always) reflects the relative strength of a nation’s economy, including its ability to service its debts, its balance of trade and its ability to attract foreign investment.

A devaluation also is medicine: It has benefits that can help make a sick economy well again. For one, a country’s exports instantly become cheaper (and thus more competitive) with a devaluation. In addition, by reducing the value of a country’s assets, a devaluation can lure bargain-hunting foreigners to invest in those assets, spurring economic growth.

Despite Brazil’s devaluation in January 1999, the country’s stock market zoomed, and emerging markets in general had a strong year as East Asian countries began to recover from their depression.

But most of the gains were taken back in 2000 as markets fell virtually everywhere. This year, thanks in part to Argentina, the average emerging-markets stock fund has fallen 7%, according to Morningstar.

Even so, that is a smaller loss than the S&P; 500’s 7.4% decline.

Is that a reason to be believe that the next 10 years might be better for emerging-markets investing than the last 10?

The bullish argument for emerging markets is that many countries, aside from Argentina, are in better economic shape than they were five years ago. But even if it’s true, it doesn’t necessarily mean that the countries’ companies, and stocks, are poised to perform better than those of the United States and other developed countries.

Emerging-market companies face all of the same managerial and competitive challenges of their developed-market peers.

Foreign investors in emerging-market companies, meanwhile, must endure those standard business risks as well as political and currency risks.

So far, the risk-versus-return equation in these markets has been nothing short of dismal for long-term investors. And Argentina offers little hope that the picture is changing.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Submerged Markets

The average emerging-markets stock mutual fund had two stellar years in the last 11. Other than those two (1993 and 1999), the sector consistently lagged behind the U.S. Standard & Poor’s 500 index--which is evident in 10-year average annualized returns. Source: Morningstar Inc.

*

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to https://www.latimes.com/petruno.