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How geo-political nervousness exposes some market realities

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In any era a war, or an impending war, is the last thing that stock markets want. At the first hint of military action, markets head south and we have the inevitable "correction" on asset valuations. Except gold and oil of course, which head the other way.

But with everything from house prices to equities seemingly going only upwards all year, the one silver lining in the grim cloud of potential conflict is that the growing house-of-cards bubble has been slightly checked.

Prices based solely on central bank action and little fundamental value creation, especially in Western Europe where unemployment is unacceptably high and many countries are still in recession, are a bubble just waiting to be burst. A slowdown in price rises because of the terrible events unfolding in the Middle East is an opportunity to inject some reality about the true global economic picture into investor expectations.

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And nowhere more so than in the "Emerging Markets" (EM). Forget BRICs, that acronym always had spurious basis in logic, it's the whole picture on the market potential of developing economies for external investors that needs to be re-assessed.

The issue is different for domestic investors. If one happens to be based in China, or Brazil, or Gabon or Tuvalu for that matter, it makes a lot of sense to consider your domestic market when placing your investment. But for outside investors, the picture is a bit more complicated and over the last 20 years they have possibly been mistaking developed country economy factors for the attraction of developing economies.

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This is because for external investors, in essence one needs growth and stability in the developed countries for the markets to believe there will be similar in the emerging economies. Since the global market was liberalized and capital started to flow freely, the latter has benefited from two things.

First, in the pre-crash era, from a cheap and plentiful supply of liquidity, and low inflation and interest rates, that drove demand for EM assets and thus resulted in prices, and returns, heading up. But it was a debt-driven demand. As this demand chased scarce EM assets, prices rose.

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Second, in the post-crash era, paradoxically liquidity remained cheap and plentiful, but this time due to central bank action on both sides of the Atlantic. So investors kept piling into EM assets.

But as developed economy markets get nervous again, this time due to geo-political worries, so we observe EM markets losing ground a little and more questions being asked about whether previous growth rates, in asset prices and GDP, can be maintained.

It's a good question to ask. The EM space is the very opposite of homogenous. Its diversity makes it a difficult market to analyse with precision, for Western investment bank analysts anyway. But what the most recent falls in EM stock markets have done is remind us, once again, that these economies remain a volatile play for external investors and, far from being any sort of risk diversification investment, closely correlated with developed economy fortunes.

Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).

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