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Emerging Market Bears See World of Worry

The third quarter of 2011 showed what can go wrong in emerging marketsas stocks in the sector fell 23 percent amid a global equity selloff. While EM bears aren’t predicting another full-scale downturn, they expect trouble for countries linked to the euro zone and those dependent on exports.

The ongoing debt issues in Greece and southern Europe continue to obscure the outlook for emerging market countries of peripheral Europe.

“Certain parts of Eastern Europe are quite high-risk,’’ says James Donald, head of emerging markets at Lazard Asset Management.

Market watchers expect Hungary, Poland and the Czech Republic, countries reliant on trade with a weakened euro zone, to suffer until the continent resumes normal economic growth.

Hungary is in the worst shape with spiraling consumer debt, currency weakness and questionable government austerity policies, with certain industries being taxed to pay for fiscal programs.

The ability of exchange traded fundsl ike Market Vectors Poland and iShares MSCI Austria — Austria is a major lender to Hungary — to be shorted makes them a useful tool to gain from such weakness.

The uncertainty of government involvement also makes Russia a less investor-friendly country. “Russia is tricky,’’ says Ingrid Baker, portfolio manager of the Invesco Emerging Markets Equity Fund. “ It’s extremely cheap [from a valuation standpoint] but the government is putting a hand in the economy, particularly in oil.”

Energy companies in Argentina are also controlled by the government, while the economy is being held back by a tight money supply.

Should exports to China and other rapidly growing EM nations slow, other South American commodity producers will also suffer.

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Brazil, one of the world’s main suppliers of food and agricultural goods, as well as iron ore and petroleum products, and Peru, a leading copper producer, rely heavily on Chinese demand.

Chile and Colombia are also dependent on natural resources. “We’re wary of the materials sector, and the susceptibility of [commodity producers] to maintain pricing through the cycle,” says Stephen Parr, a portfolio manager with Aberdeen Asset Management. China’s recent negotiation of iron ore contracts is an example of weak pricing power.

The ETF market has plenty of options to express negative views on South America, from single country funds targeting

iShares MSCI Brazil Index Fund and iShares MSCI All Peru Index to regional ones such asSPDR S&P Emerging Market ETF and iShares S&P Latin America 40 Index Fund .

Lagging consumer spending in the U.S. and euro zone could also crimp the fortunes of consumer goods manufacturers based in Taiwan and other parts of Southeast Asia.

Export-driven regions should be able to muddle along in today’s current anemic growth environment.

Should the U.S. or euro zone lapse into a double-dip recession, however, EM companies are expected to sustain greater losses than their developed markets counterparts.

In some emerging market countries with healthy fundamentals, stocks are simply too expensive to offer much upside. Invesco’s Baker, who hunts for value stocks, has lowered her exposure to Malaysia, the Philippines and Indonesia on valuation concerns.

The fall selloff in EM equities quelled fears of a speculative bubble forming. But the sharp snapback in performance and fund flows into the asset class could raise those concerns again, especially if simmering fears of inflation reignite in bellwether markets like China and India.

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MV POLAND
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