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August 26, 2013

One of the most startling developments in global equity markets in recent years has been the stark contrast in performance between developed and emerging markets. After surging 79% in 2009 as markets rebounded from the financial crisis, emerging markets have gained, on average, only a 4% total return for the entire three-year period ended July 31, 2013. This compares with a total return of almost 46% for the MSCI World Index in developed markets and 63% for the S&P 500 Index in the U.S.

Through July 31, 2013, emerging markets lost 8.4%, while developed markets gained 14.5% and the U.S. market gained 19.6%. Moreover, the larger, more established BRIC markets (Brazil, Russia, India, and China) have led the retreat. The MSCI BRIC Index declined 11.2% this year through July.

T. Rowe Price managers cite several reasons for emerging markets' stunning performance reversal but say the long-term trends remain positive.

Why Have Emerging Markets Struggled?

Economic growth, particularly in the BRIC countries, has slowed more than expected, while growth in the developed world, spurred by monetary easing by central banks, has been sluggish but improving. Gross domestic product (GDP) growth in China this year, for example, is currently estimated at about 7.4% compared with about a 10% growth rate over the past decade. Growth in Brazil and Russia has been slowed by falling materials and energy prices. Political and bureaucratic deadlock, corruption, and inefficiency in India have affected investment and infrastructure spending.

The BRIC countries were an engine of growth for both emerging and developed markets across the world, and now that engine is sputtering.

The slower pace of economic growth, cost pressures, and weak global demand from the developed world has generally led to disappointing corporate earnings since profits peaked in late 2011, particularly compared with the developed world. This trend has been most pronounced in Brazil, but consensus earnings estimates for emerging markets have been revised down.

Profit margins have been squeezed in almost all emerging markets as companies try to adjust to cost pressures. Changing government policies in some markets such as Brazil have also restrained earnings growth.

"The value of a company is determined by its free cash flow, and it's the growth of that cash flow that determines the (price/earnings) multiple investors would pay for the stock," says Bob Smith, portfolio manager of the International Stock Fund. "In the last three years, we have been reminded in emerging markets that while growth over time offers greater potential free cash flow, there have been more leaks in that bucket of cash in some emerging market companies, so for every dollar of revenue growth, you have had less free cash flow than we expected. While we attempt to own companies with fewer holes, we have been disappointed by such leaks when they occur."

Emerging markets are generally more exposed to commodity sectors, such as materials and energy, and commodity prices have fallen in recent years. Slower growth in China, a major importer of commodities, has dented demand and hurt prospects for commodity producers, such as Russia, a major oil exporter, and Brazil, a key producer of raw materials and metals, such as iron ore and copper. On the other hand, other countries, particularly those in Asia, should benefit over the long term from more subdued commodity prices.

Meanwhile, the recovery in developed markets over the past two years has been led by more defensive, less cyclical sectors such as health care, consumer staples, and consumer discretionary.

International capital flows to emerging markets have reversed with a vengeance this year, especially since Federal Reserve Chairman Ben Bernanke indicated this spring that the Fed could begin tapering its quantitative easing programs this fall, raising liquidity concerns in emerging markets, particularly those with large current account deficits, such as Turkey, India, and South Africa. Selling in emerging equity markets has been compounded by broad-based local currency weakness, further impacting returns for most investors.

Political and social turmoil in some emerging markets, such as Turkey, Egypt, and Brazil, have rattled investors, reinforcing the inherent unpredictability of emerging market investing.

Fundamental Case for EM Is Intact

The pace of economic growth in the emerging world still far exceeds that of the developed world, and this trend is expected to continue, though the gap appears to be narrowing. The International Monetary Fund estimates that emerging market economies will account for nearly half of global GDP by 2020.

Superior rates of economic growth have not always been accompanied by superior market performance. However, managers say that higher growth rates should result in better earnings for many emerging companies poised to benefit from it and that the emerging world is likely to retain an earnings advantage over the long term.

Profitability levels in the emerging world (as measured by return on equity) also remain higher than in most developed world countries, despite rising inflation and cost pressures and a collapse in commodity prices over the past two years.

The growth of the middle class and consumerism in emerging markets remains in place and is fueling growth opportunities for a wide range of consumer-oriented companies—ranging from Internet firms in China to retailers in Mexico to food companies and banks in Russia. This shift from export-led to consumption-led growth is underpinned by an attractive demographic profile in certain markets.

Two-thirds of the total emerging market population is estimated to be less than 40 years of age. A younger demographic profile with increased migration from rural to urban labor markets is viewed as a competitive growth advantage that supports the trend toward greater wealth accumulation and consumerism.

"Growing urbanization, consumption, and upward mobility are long-term secular trends that will drive strong and sustainable growth in emerging markets for many years," says Gonzalo Pangaro, portfolio manager of the firm's Emerging Markets Stock Fund.

Valuations Are Attractive Following the Recent Lag

Based on expected earnings, emerging markets sell at valuation levels reflecting discounts to the developed world not seen since 2005. In fact, the valuation gap between developed and emerging market equities is significantly greater than the average for the past decade.

On average, emerging markets are selling at a price/earnings ratio of 9.5 times the expected 12-month earnings compared with about 11x for the developed world and 14.5x for the U.S. market. Mr. Pangaro has taken advantage of the lower valuations to add to certain "high conviction," higher-quality companies that he expects to emerge stronger from the emerging market slowdown and take market share from weaker competitors.

Challenges Remain, but Long-Term Story Is Positive

Emerging markets still pose considerable risks for investors. Concerns over the Federal Reserve and other central banks reducing liquidity and the threat of rising interest rates could result in further selling pressure in emerging markets.

Also, the Fed's talk of tapering its bond purchases has particularly punished countries with current account deficits, leading to currency weakness and fears over debt sustainability. A further fall in commodity prices would have a negative impact on commodity-rich emerging nations.

If China's economy slows even more than expected or hits a hard landing, the effects would ripple throughout the emerging world.

The most important risk factor is the outlook for corporate earnings. Companies will need to deliver over the medium and long term to allay investors' fears.

Two of the big tailwinds for emerging markets—tremendous growth in China and the commodity cycle—are likely to be less important in the future. This means managers need to be even more selective as they expect to see greater dispersion in performance among sectors and countries.

T. Rowe Price managers remain optimistic about the long-term prospects; they encourage investors who have participated directly in emerging markets to stay the course and for others to consider taking advantage of the attractive valuations and growth potential many companies in these markets offer.

"Although near-term growth and earnings are likely to continue to both surprise and disappoint, many emerging market stocks offer meaningful upside potential, given their earnings power," says Scott Berg, portfolio manager of the Global Large-Cap Stock Fund. "And the long-term foundations of the emerging market growth story have not significantly changed."

Smith adds: "Investors might want to consider investing gradually in emerging markets or modestly add to their existing position. You shouldn't do it with the expectation that the underperformance of the past couple years will be made up in the next two years, but over time the growth trend should be your friend in emerging markets, and we've priced in a lot of the risks."

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