The World Bank estimates that the global economy will likely shrink for the first time since World War II - at least five percentage points below potential - and emerging markets will suffer the hardest hits with severe long-term implications.

And the most affected sectors are those that were the most dynamic not too long ago: Urban-based exporters, construction, mining and manufacturing - the result of shrinking global trade that’s on track to record its largest annual decline in 80 years.

Developing countries are facing a $270 billion to $700 billion financial shortfall. But the biggest private sector creditors are seeing the biggest loan demand for high-income countries, choking their ability to loan to emerging markets. And the emerging economies that can secure loans will face higher borrowing costs and lower capital flows, leading to weaker investment and slower growth in the future, the World Bank said.

"When this crisis began, people in developing countries, especially those in Africa, were the innocent bystanders in this crisis, yet they have no choice but to bear its harsh consequences," World Bank Managing Director Ngozi Okonjo-Iweala said in the report. "We must look at poor people as assets and not liabilities. The new globalization should mean we adopt new ways of caring for our infants, educating our youth, empowering our women and protecting the vulnerable."

All totaled, only one quarter of the most vulnerable countries have the ability to finance measures to economic downturn - such as job creation and safety programs. The rest will likely see already drastic poverty worsen, the bank said.

"We need to react in real time to a growing crisis that is hurting people in developing countries," said World Bank Group President Robert B. Zoellick. "This global crisis needs a global solution and preventing an economic catastrophe in developing countries is important for global efforts to overcome this crisis. We need investments in safety nets, infrastructure, and small and medium size companies to create jobs and to avoid social and political unrest."

The best way to ease the damage, World Bank Chief Economist and Senior Vice President Justin Yifu Lin says, would be for developed countries to spend a portion of their stimulus plans on developing countries.

"Clearly, fiscal resources do have to be injected in rich countries that are at the epicenter of the crisis, but channeling infrastructure investment to the developing world where it can release bottlenecks to growth and quickly restore demand can have an even bigger bang for the buck and should be a key element to recovery," Lin said.

Emerging markets which have too much money chasing too few investment opportunities for their own citizens will be prone to speculative bubbles; e.g. China. Prior to the bull run of the past five years, the price-to-earnings (P/E) multiple of emerging markets stocks historically averaged approximately 75% of the P/E multiple of developed markets stocks (including the U.S.), and the price-to-book multiple averaged 67% that of developed markets. Over this period (1985-2002), whenever emerging markets valuations moved to parity or to a premium to developed markets valuations, it was a signal to reduce exposure or avoid the asset class. The traditional attitude towards emerging markets stocks was that they warranted a discounted valuation because of their greater risk characteristics, their dependence on export activity rather than domestic demand, and their propensity to suffer political and economic crises.

Today, emerging markets stocks are valued at a significant premium to foreign developed markets stocks and a modest discount to U.S. stocks (see Exhibit 2). The current 20x P/E multiple of the S&P 500 is somewhat misleading because of the heavy write downs that U.S. financial firms have taken in recent quarters. On the basis of calendar 2008 estimated earnings, the P/E multiples of the S&P 500 and the emerging markets index are much closer, at 15.7x, and 13.9x, respectively.

Emerging markets which are tied too tightly to developed world markets (e.g., USA, Western Europe) will not provide the diversification perhaps expected by investors within those developed world markets.

Emerging markets also have issues with moral hazard. Local politics often win out over foreign invesment. E.g., Malaysia.

The justification for investing in emerging market stocks has always been the same – growth in emerging markets will far outstrip growth in the developed world and therefore, the profits will be greater.

After all, doesn’t it make sense that a company doing business in a country with GDP expanding at a 7% annual clip will earn way more than a company doing business in a country with GDP contracting?

Seems logical and if that’s the case, emerging markets are definitely the place to be right now. Barclays estimates developing Asian economies will grow by 5.2% this year, compared to a 2.3% contraction for the United States.

Here’s the rub: the classic justification is flawed. High economic growth does lead to higher profits for individual companies. But it doesn’t translate into higher stock returns for investors.

Based on decades of data from 53 countries, London Business School professor Elroy Dimson recently proved countries with the highest growth produce the lowest returns (6% per year), while countries with slowest growth produced the highest returns (12% per year).

How can this be? It’s simple, really. Attracted to higher growth, investors end up paying higher prices for emerging markets stocks, which cuts into returns.

Emerging markets which are tied too tightly to developed world markets (e.g., USA, Western Europe) will not provide the diversification perhaps expected by investors within those developed world markets.