Investors Pour Into Stocks Of Emerging Markets

The bursting of U.S. housing and mortgage market bubbles has suddenly been replaced by emerging markets inflating, and world equities have got pumped up into the bargain.

With the herd mentality of global investors ever sharper, the Federal Reserve's decision two weeks ago to combat a U.S. credit market seizure with lower interest rates has stampeded
investors to Asia, Latin America and elsewhere in the developing world.

Traders on the floor of the New York Stock Exchange.

Investment flows to emerging equity funds hit a 85-week high of $5.53 billion last week, with redemptions from developed market funds providing most of this cash, according to EPFR Global, which tracks funds with $10 trillion in assets globally.

Non-Japan Asia received 53% of the total.

And the price action echoes that. MSCI's index of emerging market equities has accelerated more than 13% to record highs since the Fed cut on Sept. 18 and has clocked up a whopping 36% gain so far in 2007. China's main bourse has more than doubled this year. Brazil is up some 60%.

The Next Bubble?

"I worry about emerging markets looking into next year. They are the next bubble in this environment -- especially if the Fed decides to take back its insurance rate cut," said Phil Suttle, Director of Global Macroeconomic Analysis at the Washington-based Institute for International Finance.

Suttle said the Fed ease replayed a now almost routine response to western banking stress and looked set to perpetuate a cycle of market bubbles that moved from Asia in the mid-1990s
to technology at the end of the decade and housing post-2001.

But emerging markets are particularly prone to bubble behaviour because they are small compared with the deep and mostly liquid equity and bond markets of the world's major
economies.

Analysts at Merrill Lynch estimate that equity markets in Brazil, Russia, India and China represent only 4% of world market capitalisation compared with 44% for the U.S. equity market alone.

"The short and intermediate risks to emerging market equity prices remain skewed to the upside and we continue to think that an asset bubble seems likely, led by BRIC markets," Merrill told
clients this week

Stokes Inflation

The fear is that when money starts to leak from developed to developing markets it supercharges already-elevated assets and stokes inflationary and systemic problems down the road.

"Global emerging markets are still small so asset managers' switch to emerging markets has a disproportionate impact," said Richard Batty, investment director at Standard Life Investments.

"And there is still a lot of liquidity out there," said Batty, adding up to 65-70 percent of leveraged corporate bond investor holdings are in cash right now and need to reinvest.

But the unleashing of a new wave of global liquidity comes just at a time when many policymakers and central bankers are urging caution about inflation and commodity-price pressures.

Managing those pressures will now be trickier as money sloshes around the system and surfaces in unintended places.

Fundamental factors driving funds into emerging markets are well documented.

Economies there continue to boom. The International Monetary Fund expects developing country growth, at 7.5% this year, to be three times that of the developed world.

Massive Windfalls

This boom, in turn, is fueling world commodity prices and dropping massive windfalls in commodity-rich emerging nations.

But, perhaps most powerfully, the U.S. dollar is falling sharply on the back of a U.S. economy being weakened further by housing and credit problems. The Fed cut heaped on the pressure.

This dollar weakness has tempted more U.S. funds offshore and flooded the coffers of emerging market central banks intent on preventing a greenback slide undermining thier exports.

"Mutual funds are switching away from the U.S. to emerging markets," said Batty at Standard Life, adding some of the $700 billion of U.S. equity which was dumped last year leaked
straight to emerging markets.

But why in the face of recession fears and a falling currency has Wall Street too powered to a record high on Monday?

Two big reasons are related to emerging markets too.

Rising Currency Reserves

The first is that rising hard currency reserves in emerging markets -- $4.3 trillion at the IMF's last count -- are partly being channelled into so-called sovereign wealth funds and are
expected to be reinvested over time in world markets such as U.S. and European equities among others.

Investment banks estimate the total size of these sovereign funds could climb as high as $12 trillion by 2015.

And another reason for U.S. and European equities being drawn into the slipstream is transnational firms there are increasingly dependant on earnings growth from overseas.

Bank of America estimates that overseas earnings of U.S. companies soared 16.4 percent in the first quarter of this year and U.S. affiliate sales and income in countries such as Poland,
Russia, Brazil, China and Turkey are running at record highs.

Domestic earnings by contrast rose by just 2.7 percent.

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