Investors over-weighted in the major industrialized markets since 1998 have earned poor returns in nominal terms and negative results adjusted for inflation. U.S., European and Japanese equities have ranked as some of the worst investments over the last ten years in dollar terms as two bear markets, including the current credit crisis, deflates long-term returns.

Emerging markets, however, have earned impressive inflation-adjusted returns over the last decade and have protected investors from inflation.

Indexing, unfortunately, has done a poor job over the last ten years for major market investors.
Major markets are defined by the Morgan Stanley Capital International (MSCI) World Index, created in 1969. These include the United States (48%), Canada, Europe, Japan, Hong Kong, Singapore, Australia and New Zealand.

Major Markets Flunk since 1998

Since 1998, the MSCI World Index has gained just 2.7% per annum. That return trails not only T-bills over the same period but also inflation, leaving investors with a negative real return of about -1.3% per annum. That’s hardly impressive. What’s even more depressing is the fact those returns include the benefits of dollar depreciation vis-à-vis foreign currencies in the index, or 52% of the World Index. A plunging dollar didn’t help results, either.

If global investing isn’t your thing, staying at home didn’t boost your portfolio, either.

Since 1998, the S&P 500 Index has rallied only 2.5% per annum. Adjusted for 4% annual inflation over the same period, investors have actually lost 1.5% per year over the last decade.

The only broad global index to post solid inflation-beating returns since 1998 is the emerging markets.

Emerging Markets Dominate

The MSCI Emerging Markets Index includes the world’s fastest-growing economies supported by bulging trade surpluses, booming foreign-exchange reserves and, in most cases, healthy balance sheets. The largest constituents of this index are Brazil, China, South Korea, Taiwan and Russia.

Since 1998, the MSCI Emerging Markets Index has gained 13.5% per annum or 9.5% annually adjusted for inflation. That’s the highest total return posted by any broad global index over the last decade and confirms that major markets have badly lagged emerging markets.

Indeed, emerging markets continue to post strong growth rates while the industrialized economies continue to struggle with debt deflation tied to a financial crisis, rising long-term unemployment and declining living standards. The emergence of China as a major financial power combined with rich commodity-producing nations of Brazil, Russia and the Gulf States all portend to compelling long-term future returns for investors.

Are U.S. Stocks Poised to Dominate?

Worth noting, however, is that emerging markets hit a bear market low in late 1998 following the Asian economic crisis and the Russian rouble collapse. It marked the best market-timing purchase among select global indices at the time. Maybe the same opportunity is approaching for the S&P 500 Index as that index remains hostage to a credit squeeze, deflation in housing and a decline in domestic consumption.

Amid a 13-month credit crisis affecting mostly the developed world, the United States might be on the cusp of outpacing other markets over the next decade. What happened in the emerging markets ten years ago suggests this might be possible, at least from a contrarian investor’s standpoint.

In 1998, Russia’s economy collapsed. The Russian government defaulted on its foreign debt obligations while the rouble went into a freefall. In Asia, regional governments exhausted their central bank reserves defending overvalued currencies and the resultant destruction of credit that began in the summer of 1997. This was exactly the time to aggressively buy emerging markets, and, eventually, commodities. Oil prices bottomed north of $10 a barrel in late 1998.

There’s no doubt that longer term, emerging markets will become larger and, therefore, dominate global stock market performance. Growth rates will certainly continue to outpace the major markets for years to come. But a marked slowdown in exports and a prolonged commodity slump might also crimp the near-term prospects for emerging markets. It is possible that after years of huge triple-digit gains that the emerging markets can lag the major markets, especially following the crippling declines posted by major market financial stocks. A recovery, however short-lived, will boost the value of U.S. equities as financials comprise more than 15% of the broader market and more than 20% across Europe.

Financials will Dominate

History strongly suggests that financials will eventually form a bottom and lead another broad rally for major market equities. It might be hard to make a long-term case for financial services as industry business models have radically changed and have been compromised by the credit squeeze; still, a major advance can occur even for a short period of time.

I’m certainly not long-term bullish on U.S. or European stock markets. The smart money will remain committed to emerging markets, including new frontier markets like Vietnam, Bangladesh and Botswana among others. Plus, China, India and Brazil are superb growth stories for the next ten years. But it might be time to start looking carefully again at U.S. stocks as foreigners return to asset allocate positions that have been severely pared over the last few years. A stable dollar would go a long way solidifying this possibility.