Image Credit: “Stocks Down,” lithograph, Nathaniel Currier, ca. 1849, Library of Congress
By Jason Zweig | 2:50 pm ET Jan. 27, 2016
The government massively overinvested in transportation and land development. The banking system was inefficient and corrupt. State governments gorged on debt, then defaulted on it with aplomb. The stock market was crooked, rife with cronyism and insider trading. Stocks shot up and down like yo-yos.
China? No, that’s the U.S. in the 19th century, but it has lessons for investors looking at China and other emerging markets. Financial history shows that the return on U.S. stocks during the country’s own emerging-market period was no higher than it has been since World War II. The lesson: Emerging markets aren’t lucrative investments just because they are “emerging.” They deliver higher returns only after they have been battered, as China is being battered now.
British investors learned and relearned that lesson the hard way in the 19th century, when they poured today’s equivalent of tens of billions of dollars into U.S. stocks and bonds.
They were driven by the epic, generation-long decline of U.K. bond yields from about 5.5% in 1816 to less than 3% in 1845, and again from roughly 4% in 1866 to 2% in 1897. With money so cheap, British investors helped fund the Erie Canal, successful railways and thriving telegraphs. Those who came in on the crests of euphoria lost fortunes on steamboats, mines and even municipal bonds, as state after U.S. state repudiated its debt.
In much the same way, the campaign by the Federal Reserve and the European Central Bank to slash interest rates and drive investors into riskier assets helped set off a wave of investment in emerging markets. Between 2009, when low interest-rate policies began to kick in, and the end of last year U.S. investors pumped more than $200 billion into emerging-market mutual funds and exchange-traded funds.
The overseas bubble that many Western investors have mocked is thus partly of our own making. The losses so many have incurred are largely the result of fleeing the low yields of the U.S. markets without thinking twice about the higher risks in emerging-market stocks and bonds.
“When you pull down returns on deposits to zero or below, then you create a portfolio effect that distorts markets elsewhere,” says Sandy Nairn, chief executive of Edinburgh Partners, an investment firm in Edinburgh, Scotland, that manages about $11 billion.
Emerging markets don’t offer higher returns merely because they are growing faster. Stocks gained an average of 6.7% annually after inflation between 1802 and 1870, when the U.S. was an emerging market. They’ve returned 6.9% on that basis since 1926. And the 19th century returns might well be overstated by at least a percentage point annually, given the difficulties of measuring the performance of the thousands of stocks that disappeared without a trace in those days.
Early in the 19th century, middle-class Americans began speculating wildly on stocks, egged on by financial promoters publishing tout sheets that hyped the hot stocks of the day, like the Morris Canal & Banking Co. Kickbacks and favors flew as local and state officials, as well as the federal government, pumped public funds into companies run by their cronies. Stock exchanges sprang up everywhere from Norfolk, Va., to Virginia City, Nev., and foreigners soon followed the locals in the speculation.
China’s evolution as an emerging market has thus far followed a similar path.
As a nation that aspires to be a developed market but is still emerging, China remains subject to the wrenching volatility and wild swings of sentiment that have always characterized young and rambunctious markets.
”Countries learn from their mistakes,” says Antoine van Agtmael, the pioneering investor who coined the term emerging markets in 1981. “So will China.”
Investors will learn, too, if slowly. A study of more than a century’s worth of investment returns shows that emerging markets deliver their best results not when hopes are highest, but after they break investors’ hearts.
Emerging markets handed investors a 30% loss in 2000, but then doubled in the decade of the 2000s, even as developed markets went down, according to investment research firm MSCI. Their popularity peaked in 2010. In the five years since, they have lost a cumulative 22%, even as global stocks rose 44% and U.S. stocks 75%.
With the Shanghai Composite Index down 23% so far in 2016 and 55% from its record high in October 2007, the Chinese stock market is nearing the point at which many investors are likely to give up on it. Talk of China’s graduation from emerging to developed-market status has already begun to die down.
Soon, investing cynics may start to quip that China isn’t even emerging but is rather a “submerging” market. At that point, intelligent investors should finally get excited about it again.
Source: The Wall Street Journal