Growing Pains

2006 was quite a year. Pluto was kicked out of the planetary fraternity. The Democrats took control of Congress. We lost a President and the Godfather of Soul, but we gained a Shiloh and a Suri. 2006 was also a darn good year for global investors, highlighted by the performance of emerging market equities. The MSCI Emerging Markets Index returned 29% in 2006, outperforming the MSCI World Index for the sixth consecutive year. Twenty-three of the twenty-five countries in the index posted positive returns for the year with Jordan, the smallest weight, and Turkey being the only exceptions. Combined, these countries make up just 1.6% of the index. By contrast, some of the largest developing countries had some of the strongest returns. Markets in the so-called BRIC countries - Brazil, Russia, India and China – posted returns of 45%, 51%, 43% and a whopping 129%, respectively! Despite these impressive returns, there were also unmistakable signs that emerging markets are, in fact, still emerging.

With the global economy chugging along at such a strong and steady pace, it is easy to forget the risks associated with emerging markets. Globalization is fundamentally transforming developing countries. Not only are developing economies growing rapidly, but their monetary policies, corporate governance and financial systems are improving as well. Although we can confidently say emerging markets are more economically sophisticated than they have been at any time in the past, they can still occasionally resemble drivers ed students learning the difference between the break and the gas. Varying attitudes toward free markets, deeply engrained political and cultural differences and plain old inexperience are just a few of the challenges facing developing countries.

Venezuelan leader Hugo Chavez is one of the most outspoken opponents of western style capitalism. His most recent slapping of the invisible hand included a declaration that he intends to nationalize many of Venezuela's power and telecommunications companies. In addition, Chavez aims to amend Venezuela's constitution to eliminate the independence of the country's central bank. Chavez's attempts to create a "socialist republic of Venezuela" don't bode well for the country's economic growth or for foreign companies that have invested in assets there.

Malaysia is a country struggling with political and religious strife. The current and former prime ministers are at each others throats resulting in political gridlock that has inhibited many pro-growth reforms. But the country's leaders aren't the only ones who can't get along. Malaysia's native Malay Muslims continue to butt heads with Chinese and Indian immigrants over race based quotas intended to increase business ownership by native Malay's and give them preferential access to jobs and education. Keep in mind that Malaysia didn't gain independence from Brittan until 1957, so dealing with these issues as an autonomous country isn't exactly old hat.

Phenomenal growth is making emerging economies some of the world's largest. China recently overtook the United Kingdom as the world's fourth largest economy, and China's domestic equity markets have topped the $1 trillion mark, ranking them ahead of many developed markets including Spain and Australia. But even China, the world's fastest growing large economy, is struggling with its new position as a dominant world player. A large trade surplus and restrictions on capital flows have resulted in both current and capital account surpluses. Consequently, the economy is awash in excess liquidity which the government is desperately trying to absorb. China is now faced with the challenge of implementing monetary and fiscal policies that will prevent the economy from overheating without derailing it altogether.

Thailand finished the year with some significant missteps. Investors were able to shrug off a military coup in September, but capital controls introduced in December are shaking investor confidence in the new regime. The Bank of Thailand immediately reversed course after equity markets suffered huge losses, but it could take time to convince investors that this sort of error is the exception rather than the rule.

Developed markets aren't immune from many of these same issues. Political infighting is as prevalent here in the US as anywhere, and you would be hard pressed to find any central bank that hasn't made some questionable decisions. But developed economies tend to be large enough, diverse enough, and experienced enough to weather these problems without causing investors to run screaming to their brokers. Given their increasingly important role in the global economy, it's clear there is a place for emerging markets in a well diversified portfolio, but you might not want to convert your nest egg into Baht just yet.