Emerging markets lead to asset bubble

Little more than a year after global financial markets collapsed and the US housing bubble burst, developing countries are giving birth to a new asset bubble - one that investors bet will keep growing for some time.

Cash has been flooding into emerging markets since March. Investors in pursuit of strong returns see countries such as China and Brazil leading global growth in the next few years, while developed world economies are expected to remain nearly stagnant.

Those capital flows, which have been super-sized by the ample liquidity measures taken by central banks to fight the crisis, have lifted emerging market stocks more than 70 percent so far this year, according to the benchmark Morgan Stanley Capital International (MSCI) Stock Index.

In Latin America, stock prices have soared more than 90 percent this year on the MSCI. Currencies like the Brazilian real gained more than 30 percent.

And even though most of the gains simply account for a rebound from last year's meltdown, some investors predict the rally is just starting, with only short-term corrections coming along the way.

"I think there may be a bubble forming in some emerging market stocks, not just in Latin America. You see the same kind of pattern in Asia," said David Wyss, chief economist for Standard & Poor.

"There is just a lot of cash looking for yield and not quite believing that you can't get 19 percent a year anymore," Wyss said, referring to the average returns of the S&P 500 during the 1980s and the 1990s.

Jeremy Grantham, co-founder and chief investment strategist of the privately owned investment management firm GMO, forecast that the premium over earnings that investors pay for stocks in some emerging markets could reach 50 percent in coming years.

Those countries have "the people, the savings and the attitude" to convey a compelling growth story, Grantham said.

Currently, emerging market stocks trade on average at a 13.6 percent premium of price to earnings, according to estimates from Thomson Reuters' StarMine.

"On a dividend discount model, emerging is already overpriced," Grantham said. "But it has an appealing story that will transcend its value limitations. In other words, it will have a bubble."

Governments in many developing countries have already expressed concerns about the magnitude of capital inflows, which they see as a threat to exporters due to the currency appreciation.

But attempts to reduce those inflows have proven ineffective so far. A 2 percent tax on foreign capital imposed by Brazil earlier this week brought only temporary losses to the Bovespa stock index and its currency.

The Brazilian benchmark stock index is still up some 75 percent so far this year, and some analysts see it rising another 15 percent by the end of the first quarter of 2010.

Underscoring the huge appetite for emerging markets, stock funds dedicated to the asset class saw enough inflows this year to recover all of their 2008 redemptions and beat the record inflows of 2007, according to an Emerging Portfolio Fund Research (EPFR) report.

Investors seem unlikely to back off from emerging markets any time soon.

"Allocations to equities and emerging markets have risen, but remain well off the highs seen this decade. A bubble may yet emerge in Asian asset prices, but it is premature to consider a bursting of one," UBS economist Larry Hatheway said in a research note.

GMO's Grantham said he thinks a new bubble "will suck in the money and it will go higher and higher".

He remains overweight in emerging markets, he said, even though it is becoming increasingly difficult for value-focused managers to justify current valuations.

"But if you want to live a little bit fast and loose, I think it's going to go up," Grantham said.

Reuters

(China Daily 11/02/2009 page4)