Emerging Markets: Higher Returns With Lower Risks?

MarketWatch has a column extolling the virtues of investing in emerging markets and discussing some research by Renaissance Capital suggesting that certain emerging markets may not be as risky as common wisdom would have it..  Author Matthew Lynn opens with an assumption stated as a fact:

"If there is one thing that we know for sure about the global markets over the next few years, it is that the returns from all the developed countries are going to be pitiful.

The U.S., Europe and Japan are weighed down by massive government and consumer debts. They are going to struggle to get back on a sustained growth path. Emerging and frontier markets are the only places you are likely to get meaningful returns on your money"

This may be the case, but it is by no means certain.  Developed economies have been delevering themselves over the past three years, with the private sector paying off more debt than governments are borrowing. In response corporate earnings, at least in the U.S., are growing nicely.  Once the recovery takes a firm hold, the government borrowing issues will work themselves out.  There is no reason to believe that return to the equity markets of developed countries necessarily will be "pitiful."

More interesting is the research that suggests that emerging markets may not be subject to the political risk that we all assume.  Renaissance Capital studied 150 countries over the period 1950 - 2009 and found a relationship between per capita GDP and the risk of government overthrow.  Among democracies the demarcation is at $10,000.  No democracy with per capita income experienced an overthrow during the period studied.  Among autocracies, the critical levels are $6,000 and $10,000, between which the risk of insurgency is high.

The study is not available, so I could not determine how the details were worked out, but the article includes a little hint of the biases working.  The article notes that Renaissance Capital is an investment bank specializing in emerging markets, so it is likely to emphasize the positive of any findings there.  Furthermore, government overthrow is not the only way that political risk can be manifest; there are also nationalization, currency debasement and regulatory overreach, among others.

The most glaring item though is this: "...Russia is now a stable democracy. There is little chance of it reverting to autocratic rule."  Well, excuse me, bu the CIA disagrees: "Russia has shifted its post-Soviet democratic ambitions in favor of a centralized semi-authoritarian state whose legitimacy is buttressed, in part, by carefully managed national elections, former President PUTIN's genuine popularity, and the prudent management of Russia's windfall energy wealth."  This makes me wonder how Renaissance Capital classified such democracies as Venezuela and Iran.

The expected returns to emerging markets should be higher than it is for developed markets because the risks there are greater.  These increased risks include the political but also economic: emerging economies tend to be undiversified, reliant on the production of commodity inputs, and having very short histories with economic institutions that promote stability..