Emerging club mixes cocktail of high gains

Emerging markets have been shooting out the lights in recent years.

This year, the performance has continued in spite of turmoil on world markets and a slowing US economy, the traditional driver of demand for emerging markets.

With the overall global economy still firm, the MSCI Emerging Markets index has risen 16.6 per cent, outstripping the 9.3 per cent gain in the FTSE World index. That came after a strong 2006, where emerging markets surged 29.2 per cent, while the rest of the world advanced 18.8 per cent. It is a similar story in the hedge fund world.

From the beginning of the year to the end of May, the Hedge Fund Research index of emerging market hedge funds rose 12.19 per cent. That trounced the 7.19 per cent gain for the index of overall hedge fund performance.

The club of countries posting gains of more than 20 per cent in the year to date includes Pakistan (up 35.1 per cent), Finland (20.6 per cent), Portugal (23.4 per cent), Chile (25.8 per cent), Malaysia (26.77 per cent), Philippines (24.5 per cent), Singapore (21.7 per cent) and Brazil (21.5 per cent).

But these the performances have been put into the shade by the extraordinary rise of the Chinese stock market. After posting gains of 130 per cent, the Shanghai market has rallied a further 57 per cent in 2007, intensifying widespread concerns that a bubble has developed in the bourse that is about to burst.

The Shanghai B share market – for mainland-listed, foreign currency-denominated stocks – jumped 123 per cent.

Even periodic sharp sell-offs in the market have failed to shake the confidence of domestic investors who have been rushing to open trading accounts. At the height of the last bull market in 2000-2001, there were about 60m trading accounts. Now there are more than 100m, easily outnumbering the more than 75m Communist Party members.

However, Christian Deseglise, global head of emerging markets business at HSBC Investments, says that although equity prices have surged spectacularly in recent times, this does not in itself mean that China is, by definition, a bubble, or that it will burst.

“It would be near impossible for anybody to make a case for Chinese equities being cheap, but in terms of both the trailing price/earnings ratio and dividend yield, the valuation of the Shanghai Stock Exchange does not appear to be much more expensive than that of the Nasdaq Composite,” he says.

However, investors outside China have been voting with their feet. Emerging Portfolio Fund Research estimates that outflows this year from China and Greater China Equity Funds have risen to $4.8bn. That compares with net inflows of $10.46bn during 2006.

“China has really been hammered,” says Cameron Brandt, global markets analyst at EPFR.

The flow of funds into emerging market funds has been strong, particularly from US investors who still appear to be shifting money from domestic funds to invest internationally.

EPFR says the inflow of money into all emerging market funds is up 14.2 per cent this year. The big winner has been Latin American funds, which have seen the flow of investment rise 25.5 per cent in spite of concerns that the region is exposed to a slowing US economy.

Mr Brandt says Latin America may be benefiting from the fact that it has lagged other emerging markets in recent years and by the progress of reform in Brazil and Mexico. He says that, ironically, Latin America flows may have been boosted by investors seeking an exposure to growth in Chinese demand for products and commodities.

But he says there has been growing discrimination from investors between individual countries, particularly those falling into the Europe, Middle East and Africa (EMEA) category of funds.

“Sources of capital do seem to be leery of countries and regions running big current account deficits. That has hurt EMEA funds, given the current account deficits being run by Hungary, South Africa, Egypt and Turkey, and has started to weigh on India country funds as well,” he says.

The flow of money into EMEA funds is up just 6.27 per cent this year, while Indian funds have seen an outflow of $1.67bn this year.

More broadly, some strategists still debate how long the good times can continue for emerging markets, particularly if global interest rates rise.

Michael Hartnett, chief emerging markets strategist at Merrill Lynch, cites an augury of tougher times.

“So I sat down to watch a Yankees game. A car commercial came on. A mother and two boys sit at the breakfast table eating cereal. Mom says to the kids: ‘I can’t believe how much money I’ve saved with our new hybrid. What shall we spend it on?’ ” he says.

“The 11-year-old looks up from his bowl and says: ‘Have you thought about investing in hedge funds?’ Then the nine-year-old looks up and says: ‘Yeah, what about emerging markets?’ I almost fall off the couch and turn to my wife, who’s overheard the whole thing, and ask: ‘You’re the consumer, what the hell does that mean? I’m an emerging market bull!’ .

“Without batting an eye she says: ‘It means you’ve got one more year.’ My gut tells me she’s right.”