Jonathan Clements at the Wall Street Journal asks the question: Will higher expected economic growth in the emerging markets (6% vs. 3% for the developed world) translate into higher equity market returns? Over the past year the MSCI emerging market ETF (EEM) has outperformed the MSCI EAFE (EFA) as you can see from the graph:

The underlying premise of the emerging markets thesis is for many driven by the idea that higher economic growth will lead to higher equity returns. The other being the notion that emerging markets are good portfolio diversifiers. There are indeed good reasons to believe that the emerging markets will continue to grow at a more rapid rate than the developed markets, but that may not be enough:

Here, however, is possibly the most surprising drawback: There’s no guarantee that the developing world’s rapid economic growth will fuel sparkling stock-market returns.

For proof, consider a working paper by academics Elroy Dimson, Paul Marsh and Mike Staunton. They looked at the performance of 17 national markets over the past 105 years.

Their jaw-dropping conclusion: High-growth economies don’t post the highest stock-market returns. In fact, if anything, low-growth economies seem to have the performance edge.

How can that be? In fast-growing economies, the truly rapid growth may be occurring among private, entrepreneurial businesses, not publicly traded companies.

At the same time, these publicly traded companies might regularly sell more shares, so they have the capital to finance further business expansion. Even as this new investment capital spurs economic growth, it may not do much for existing shareholders, who have seen their ownership stake diluted.

“We aren’t presenting a case for avoiding these markets,” says Mr. Dimson, a finance professor at London Business School. “We aren’t forecasting that they will have inferior returns. But those who think high-growth economies will produce superior returns have history against them.”

Another academic paper on the subject by Jay R. Ritter entitled, “Economic Growth and Equity Returns” comes to the very same conclusion. From the abstract:

It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labor force participation, and from technological change. If increases in capital and labor inputs go into new corporations, these do not boost the present value of dividends on existing corporations. Technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs. Countries with high growth potential do not offer good equity investment
opportunities unless valuations are low.

The bottom line from this research is that growth comes at a price. Good growth need not equal good returns. Investors need to heed valuations as well. Many investors learned this hard lesson during the Internet boom.

Clements advises investors put no more than 5-8% of their stock allocation into emerging markets. This should be viewed in context with his recommendation of 25-30% total international equity exposure. While conservative, this is not out of line with the recommendations of some high profile institutional investors.

David Swensen the manager of Yale University’s endowment in his new book, “Unconventional Success: A Fundamental Approach to Personal Investment,” notes that long term investors should have 5% of their portfolio in emerging market equities. That is in contrast with 15% in developed foreign equity and 30% domestic equity. Lynn O’Shaugnessy has a good summary of Swensen’s recommendations here.

Earlier this year Jeremy Grantham a founder of Grantham, Mayo, Van Otterloo remarked to Barron’s that amid a generally gloomy market outlook, emerging market equities by far and away their favorite asset class.

Clements recommendations are generally within the broad prescriptions of the financial community. While there are good reasons to hold emerging market equities, beware anyone making the case pushing the growth argument:

“Growth stocks may grow faster,” says Jeremy Siegel, author of “The Future for Investors” and a finance professor at the University of Pennsylvania’s Wharton School. “But are you paying too much for that growth? That’s critical for countries as well as individual stocks.”

Prof. Siegel cites China. “It’s been absolutely astonishing,” he says. “Since 1992, China has had the fastest economic growth and the worst stock-market returns.”