The train kept a-rollin’, all night long,
With a heave, and a ho,
Well I just couldn’t let her go.
–The Yardbirds
Risk, we’re so often told, reaps reward. If there are exceptions to this rule from time to time (and there are) it’s less than crystal these days.
As the chart below reveals, risk across the board has paid off handsomely in the recent past. As a snapshot of the past, this is a reason to celebrate, at least for those who’ve been long in certain asset classes. But the chart also represents a challenge, namely, where to deploy money now? Does this chart draw the profile of bull markets still in their prime? Or does the layout of the returns give you pause?
Emerging markets stocks, the riskiest of the asset classes in our survey, is the clear leader so far this year and for the past three years as well. In fact, equities generally, and a broad mix of commodities, occupy the top half of the performance roster, while the lagging returns are populated exclusively by bonds of various kinds, the so-called safer investment species. The pattern is true for both year-to-date and trailing 36-month returns through May 2.

Indices/Funds: MSCI EM ($), Russell 2000, MSCI EAFE ($), MSCI REIT, S&P 500, DJ-AIG Commodity, ML HY Master II, 3-mo T-bill, Pimco EM Bond Fund ($), Lehman Bros. Aggregate, Pimco Foreign Bond ($), Vanguard Infl Prot Sec
The dollar-based advance in emerging markets stocks is especially hot. The MSCI Emerging Markets equity benchmark has soared by annualized 42% a year after translating the gains back into greenbacks. By any standard for asset classes, American investors have been treated to a level of profits rarely witnessed in so short a period. Even the red-hot commodities sector overall hasn’t kept pace with the stocks of emerging markets from a dollar-based perspective.

The ascending state of equity prices in developing markets may be eye-popping, but is it speculative? Not necessarily. As the IMF noted in its World Economic Outlook published this month, “Growth in most emerging and developing countries
remains solid, with the buoyancy of activity in China, India, and Russia…being particularly striking.”
And the good times are expected to keep rolling along, or so GDP predictions imply. On a relative and absolute basis, forecasts for real GDP growth for emerging markets are impressive, not to mention well above those for developed nations as a whole. The “emerging Asia” countries, for instance, are expected to deliver real GDP growth of 7.9% and 7.6% this year and next, respectively, the IMF reports. Meanwhile, “emerging Europe” is looking good too with an expected real GDP rise of 5.3% for this year and 4.8% in 2007. Even the ailing Africa is thought to be on track to muster real GDP growth of 5.7% this year and 5.5% next year.
The developed economies too will keep growing, although the outlook generally pales by comparison with emerging markets. In fact, a growing number of forecasters expect the great engine of global growth of recent years–the U.S.– to falter, if only slightly later this year and on into next. As Northern Trust’s Paul Kasriel explained yesterday in an interview with CS, the United States is on track for decelerating growth.
If so, the question becomes: what fallout, if any, will an American slowdown have on emerging markets? The United States has been sucking in imports in ever greater quantities, and in the process sending vast quantities of dollars abroad. The trend has benefited emerging markets in no small degree. China, to cite the obvious example, now sits on dollar reserves that are the world’s second largest, a testament to the economic opportunity that’s come by way of U.S. growth. Does the process work in reverse if American GDP decelerates? If so, what does that imply for equities in those otherwise sizzling emerging markets?
Such worries are of no concern at the moment to investors in the stocks of developing countries. The bull market train just keeps rolling. In just the past four weeks, for instance, the MSCI Emerging Markets index has jumped over 7%. v. 0.9% for the S&P 500. Relative outperformance rarely looked so sexy.
But every bull market has its limits, in part because every bull markets sows the seeds of its own demise. Timing, of course, everything. It may be later than you think.