Suddenly, the assumptions that have long fed emerging-markets enthusiasm look quite wrong

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As Russian missiles bombard Kyiv and as China’s President Xi Jinping prepares to cement his status as that country’s absolute leader, investors should acknowledge a simple truth: We were wrong about emerging markets.

Not that long ago, it seemed obvious that up-and-coming countries would deliver both high returns to investors and increasing levels of democracy to their citizens. Neither assumption turned out to be true.

The past 12 months have demonstrated with remarkable force how deep the problems run, both for humanitarians and for profit seekers.

One early sign was President Xi’s out-of-the-blue crackdown on his country’s technology giants early last year, which slammed the share prices of one-time stock market darlings such as online retailer Alibaba and delivery giant Meituan. That was followed by growing international condemnation of Beijing’s treatment of its Uyghur minority as well as signs of deep distress in China’s enormous property sector. Over the past 12 months, the country’s CSI 300 stock market index has lost 16 per cent.

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The only good thing you can say about China’s bad year is that it pales in comparison to what is happening a few thousand kilometres away. Vladimir Putin’s brutal and unprovoked invasion of Ukraine is slaughtering innocent civilians. The West has retaliated with sweeping financial sanctions against Russia. The ruble has crashed, the Moscow stock exchange has closed, and U.S.-based exchange-traded funds that held Russian stocks have plunged 70 per cent.

Let us be clear here: Investors’ losses are trifling compared with the suffering of Ukrainians and China’s ethnic minorities. Human rights matter far more than portfolio returns.

But what the past year should do is to prompt anyone who owns an emerging-markets fund to ask themselves whether this is what they signed up for, either ethically or financially. Globalization no longer seems like such a sure bet. Neither does the steady advance of democracy.

The core assumption behind the enthusiasm for emerging markets that broke out around 2000 was that politics no longer mattered. The world had reached “the end of history,” U.S. political scientist Francis Fukuyama argued in a famous essay. Liberal democracy had triumphed. Money and technology would inevitably flow to the world’s developing democracies and allow them to converge economically with developed countries in short order.

The market bought into this optimism with gusto. In 2001, Goldman Sachs economist Jim O’Neill coined the acronym BRIC to describe the rising economies of Brazil, Russia, India and China. Those four emerging powerhouses would drive global growth for the next 10 years, he predicted. Other analysts quickly supersized his notion and forecast the four BRIC economies would dominate the global economy by 2050.

In fact, the BRIC thesis didn’t even last a decade. When the financial crisis hit in 2008, Brazil and Russia turned into economic tortoises. Some of their troubles over the following decade had to do with a slump in commodity prices. The more fundamental reasons for their slow growth, though, were broken political systems that blocked attempts to crack down on corruption and introduce productivity-boosting reform.

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Politics do matter after all, it seems. This holds true today even in China, one of the biggest winners of the past two decades. It now faces a difficult transition away from a development model based on infrastructure projects and large-scale manufacturing. As that model reaches its limits, growth is slowing, but the powers-that-be in the Communist Party appear reluctant to move toward an economy based more on services and consumption, in part because that would mean ceding some of their authority.

President Xi, in particular, is leaving no doubt about who is in charge. He is expected to secure an unprecedented third term as leader at the Communist Party’s 20th party congress later this year and his autocratic grip on his country shows no signs of relaxing.

So what remains of the emerging-markets enthusiasm of 20 years ago? Not much. Goldman Sachs closed its original BRIC investment fund in 2015 after years of weak returns and rolled the assets into a broader emerging-markets product.

Unfortunately, betting on a broader set of markets hasn’t been a road to riches, either. Over the decade that ended in January, stocks in the wide-ranging MSCI Emerging Markets Index vastly underperformed, producing returns of 4.2 per cent a year, compared with 11.5 per cent for stocks in developed countries.

Maybe this is just a temporary blip. More likely, though, it is a sign of just how difficult it is for emerging economies to stay on the path to prosperity. While a handful of countries in Asia – China, South Korea and Taiwan – have achieved transformational growth over the past 20 years, their success is the exception, not the rule. For every China, there is a Mexico. For every South Korea, an Argentina.

The MSCI Emerging Markets Index is now largely a bet on four superstar Asian economies – China (which makes up 32 per cent of the index), followed by Taiwan (16 per cent), India (13 per cent) and South Korea (12 per cent). These four stars could continue their upward trajectory, but their continued success is no longer the sure bet it once seemed.

Tensions between China and the U.S., and between China and Taiwan, top the list of challenges. In addition, there are pandemic-inspired moves by North American companies to shorten their supply chains and bring key manufacturing closer to home. Intel Corp.’s plan to invest US$20-billion in an Ohio microchip factory could herald the start of a wider move to claw back the manufacturing jobs that were lost to Asia.

A new financial order may also be in the offing. The Ukraine war has demonstrated how the West can use a U.S.-dollar-based international banking system to impose sanctions on countries. Presumably, Beijing is taking notice. Expect it to look for ways to increase international usage of the yuan and decrease the centrality of the U.S. dollar.

“China won’t risk accelerated decoupling with the West in order to support Russia,” Neil Shearing, group chief economist at market researcher Capital Economics, wrote last week. “But it is likely to redouble efforts to increase its self-sufficiency in key technologies and to develop international economic and financial relations that are not dependent on financial plumbing in the West.”

All of this argues for a global economy that will be more fragmented, more uncertain and less democratic than most people assumed a few years ago. Emerging-markets enthusiasts may want to recalibrate their bets.

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