The Long Road to Nowhere

Of course, the hard-core bears argue that if the United States has given up its entire bull-market gains, then emerging markets should follow the same path. But the difference is that while the U.S. growth cycle from 2003–07 was entirely built on liquidity support, with $4 of debt required for every $1 of additional GDP growth, at least some of the growth in emerging markets during 2003–07 was genuine.

To be sure, the acceleration in the growth of developing countries from 3.6 percent on average prior to 2003 to more than 7 percent over the following five years was an aberration largely rooted in the global credit bubble. Still, emerging markets are nowhere near as leveraged as the United States and therefore should be able to expand at their old average pace of 3.5 to 4 percent. Furthermore, emerging markets began their bull run in 2003 at much lower valuations than the United States and are currently trading at a 25 percent discount to the developed markets on a PE basis.

The case for equity markets' entering a stable trading range is obviously predicated on the belief that globally concerted policy action will prevent a complete Armageddon-type scenario. If the deleveraging cycle continues unabated, then all bets are off. On the other hand, the few contrarians left standing make the case that bull markets are always born in despair, and that's exactly how sentiment can be described today. While such miracles can happen, the psychological trauma of today's bear market is so deep that it will be a while before investors start taking any risk again.

Conditions then point to an era in which markets trade within a broad but firmly capped range and the global economy undergoes the painful adjustment process of moving to a lower growth trajectory. In effect, from here on we're on a long road to nowhere that is likely to exhaust both the bulls and the bears.

Sharma is head of emerging markets at Morgan Stanley Investment Management.

© 2008