To many Americans, especially the investing class, the last decade was a lost one. It started with the bursting of the dot-com bubble, followed by the 9/11 tragedy, and ended with a financial crisis that plunged the economy into the deepest recession since the Great Depression. During the 10 years from 2000 through 2009, the S&P 500 Index had an annualized total return of negative 0.95%. Developed markets as a whole also fared rather poorly, with the MSCI World Index eking out a meager 0.3% annualized total return during that period.

Meanwhile, emerging markets were experiencing rapid and prosperous growth, especially from 2000 through 2007. The acronym BRIC (Brazil, Russia, India, and China) was presciently coined in 2001 to highlight the largest and the fastest-growing developing economies. Indeed, each of the BRIC markets generated double-digit annualized total returns in U.S. dollar terms during America's "lost decade" (Table 1). Emerging markets as a whole, as measured by the MSCI Emerging Markets Index, also achieved a respectable 7.3% annualized gain during that period, substantially ahead of most developed markets. Although emerging markets suffered a steeper decline in 2008 (MSCI Emerging Markets lost 53% vs. MSCI World's 40% loss) than developed markets, they also mounted a much stronger rebound in 2009 (78.4% vs. 30.8%). In short, emerging market investments have become so well-known and sought after that it is probably passé to crow about their growth drivers - rising standards of living, stronger balance sheets, abundant natural or human resources, etc. Rather it is perhaps more interesting to discuss what we believe to be the single biggest contributor for emerging markets' phenomenal growth during the last decade - China.



China's impressive economic development at roughly 10% annualized real growth (14% nominal growth in RMB) from 2000 through 2011 has been well documented and much admired. A major contributor to this impressive growth was an unprecedented infrastructure build-out. As shown in the accompanying chart, infrastructure investment has surged from 34% of China's GDP in 2000 to 46% in 2011. It is no wonder that Chinese skylines are often dotted with cranes and towering new construction sites, overcast with gray smog that blocks out the blue sky.

While infrastructure growth accelerated, consumer spending as a percentage of China's GDP steadily declined from 46% in 2000 to just 35% in 2011. Although consumption still grew faster than that in most other economies, China's consumer spending at 35% of its GDP was exceedingly low compared to fellow BRIC countries' consumption shares at 67%, 52%, and 63%, respectively, for Brazil, Russia and India (not to mention the U.S. consumption at 71% of the economy). This infrastructure-heavy development model was characterized by Chinese Premier Wen Jiabao as "unstable, unbalanced, uncoordinated and unsustainable."

As a result of China's infrastructure investment, the country's iron ore consumption has grown at 14% per annum over the last ten years, from 265Mt, or 26% of the world's production in 2002, to 1,000Mt in 2011, a whopping 50%+ of the world's production. China's iron ore import has ballooned from 22% to 61% of the global seaborne iron ore market during these ten years. While the world's iron ore production has grown at about a 7% CAGR over the last decade, prices have skyrocketed more than tenfold, from $13 per metric ton in early 2002 to $136 per metric ton at the end of 2011. Other base metals such as copper, zinc and nickel have also experienced similarly strong growth in volume and price as China is their largest consumer.  This so-called commodity super-cycle has greatly benefited resource-rich countries, many of them in emerging markets, to create a virtuous circle that fueled their economic growth and market returns. Interestingly, during the last decade one could have achieved similar or better returns by investing in mining related stocks in developed markets instead of emerging markets per se. To wit, the MSCI World Materials Index (mining stocks in developed markets) achieved 6.3% annualized gains during the last decade; BHP Billiton, the Anglo-Australian global mining giant, achieved 23% annualized return from 2000 to the end of 2009.

Unfortunately, to quote Krishnaism philosopher/Beatles musician George Harrison, "All things must pass." After last decade's substantial outperformance, emerging market equities have lost steam so far this decade. As shown in Table 1, since the beginning of the current decade, the MSCI Emerging Markets Index has posted an annualized loss of 1.1%, and BRIC markets have lagged even more. The MSCI World Materials Index and BHP were also in negative territory, with annualized losses of 3% and 6.8%, respectively. The S&P 500 Index was up 9.2% annualized during this period.

One can attribute several factors to emerging markets' recent underperformance, including tightening policy responses to inflation in 2011, and economic concerns induced by the European debt crisis. However, this underperformance also coincided with China's policy shifts on infrastructure investment. For example, China's railway infrastructure construction spending dropped 33% from 700 billion RMB in 2010 to 469 billion RMB in 2011. China's once red hot real estate market has been losing altitude as a result of China's coordinated policies to tame the housing bubble. Earlier this year, China officially lowered its real GDP growth target from 8% to 7.5%, and emphasized the need to boost private consumption to transform its unbalanced development model. In short, the days of unbridled infrastructure build-out in China may be coming to a close, even if the Chinese government re-accelerates certain projects in the second half of this year to stimulate its softening economy.

As China transitions its economic model from infrastructure-fueled to consumption-driven, one has to consider if the commodity super-cycle has seen its best days and the ramifications for countries that have benefited from the super-cycle. It may be early to pronounce that the commodity super-cycle is over - another round of quantitative easing by the Federal Reserve could potentially inflate commodity prices higher. However, over the long run, real demand matters. One has to ask who will pick up the slack should China's appetite for base metals starts to wane. Optimists can always look to India, the world's second most populous country with 1.2 billion people. As those who have visited can relate, however, India seriously lags behind many other countries in basic infrastructure from roads and ports to energy generation facilities. Unfortunately, developments in India are often hampered by uncertain regulatory policies, red tape, and political squabbling, as discussed in David Harris' lead article. As such, there is much doubt about whether India will become the key marginal buyer of commodities in the near future.

Will emerging markets regain their outperformance in the absence of continued strength for commodities? They should improve over time as these markets still have better secular growth prospects and their valuations appear attractive. However, the magnitude of the outperformance may not come close to last decade's feat. One lesson investors should have learned is that the "decoupling thesis" - that emerging markets can plow ahead while developed markets stagnate - has been debunked over the last few years. Many emerging markets are export-driven, so their fortunes are affected by demand from developed markets, which still account for roughly 60% of the global economy. The performance of the MSCI Emerging Markets index, as discussed above, reveals this correlation. This is the reason that China and many other emerging markets felt the urgency to stimulate domestic consumption to stay on the growth track. However, these transitions from export-dependent to internal consumption-driven are likely to be bumpy and could lead to volatile and, at times, undesirable investment outcomes.

Instead of framing the investment decision around geographic allocation - developed vs. emerging; U.S. vs. international - we would prefer to examine opportunities unconstrained by national boundaries. The location of a company's headquarters is not as important as the destination of its products and services. For example, the oil and gas exploration and production company Tullow Oil plc is headquartered and listed in London. However, 74% of its production and 93% of its reserves and resources are based in Africa. Should Tullow Oil be classified as a UK or an emerging market stock? South Korean technology behemoth Samsung Electronics derives only 16% of revenues from its home country and more than 50% from Europe and the Americas. Should it be classified as a developed or an emerging market stock? In short, investors should focus on opportunities related to emerging market developments rather than emerging market stocks per se.

As for opportunities related to emerging market developments, we continue to see secular growth in energy infrastructure, dietary improvement, healthcare, transportation capacity, and consumer goods from basic necessities to luxury items. That said, from time to time there will be cyclical headwinds as nothing grows uninterrupted. One must also be disciplined with valuation as some of the less liquid markets are prone to be driven to excess by the inflow of hot money. Indeed, some promising markets are not easily accessible to global equity investors due to regulatory or liquidity constraints. Myanmar, for example, is viewed by many as one of the most exciting new markets, as this resource-rich country of 60 million people is emerging from years of isolation. To put its population size in perspective, it is the 24th most populous country in the world, just behind Italy and ahead of South Africa, South Korea, and Colombia. Yet Myanmar's stock exchange is still in the planning stage and will not open for business until 2015.

The lack of a stock exchange has not, however, stopped hot money from bidding up asset prices in this "next big thing." Although Myanmar is one of the poorest countries in the world with a per capita income of less than $900 - ranked behind 154 other countries in 2011 according to the IMF - the property value in the center of capital Yangon has already been bid up to global metropolis levels. Real estate properties in some Yangon neighborhoods are reportedly selling for 2 million kyat ($2,366) per square foot! Granted, this may be an exaggerated figure, or just representative of a few ultra-high end properties in Yangon. However, a quick search on the web identified a 15-year old, 1,571 square feet 3-bedroom apartment in Yangon with an asking price of $1.22 million ($780 per square foot). It may not be a shocking figure for New Yorkers, but it is certainly a big price tag for a country where 75% of the population still does not have access to electricity. It reveals how hot money can quickly bid up asset prices in emerging markets (Myanmar is an even less developed frontier-market) long before these countries' potentials are realized. Beware of speculators who know the price of everything, but the value of nothing.

Jimmy Chang, CFA, is a senior portfolio manager with Rockefeller Financial. 

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