Can the emerging bull market continue?

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Michael Hartnett, chief global emerging markets equity strategist at Merrill Lynch, identifies key emerging market trends and offers strategic insights and solutions to institutional and retail investor clients. Mr Hartnett answers FT.com readers’ questions on emerging markets below.


I am a believer in the encouraging long-term prospects of the Asia Pacific region and what I would call a China-driven commodity demand theme. But when I look at the charts of many of these companies, I am reminded of the charts of many of the tech companies in 1999-2000. In your opinion, are current stock prices more a reflection of a momentum market or fundamentals? What is your outlook for emerging markets equities?
Chuck Betz, Minneapolis

Michael Hartnett: Current stock prices in the China A-share market are more a reflection of momentum than fundamentals. But there are other China-related stock indices that look better value, the H-shares in Hong Kong and the S-shares in Singapore being two examples.

The risk of an investment bubble in emerging markets is very high. Every decade has seen a strong bull market mutate into a mania phase and emerging markets look the prime suspect this time around.


The current rally in EM aside, which are the three largest structural themes in emerging markets going forward?
LB Fredslund Madsen, Gibraltar

Michael Hartnett: The three best structural investment themes in emerging markets are 1. infrastructure via EM industrial stocks (Merrill Lynch forecasts $1,300bn of spending on EM infrastructure in the next three years), 2. consumer via small cap stocks (to play the domestic demand story) and 3. frontier markets for uncorrelated growth.


Which regions within the global emerging markets have the most attractive valuations currently?
Stephanie Thng, Singapore

Michael Hartnett: Emerging market investors have become more discriminating in the past year. The ”strong” economies like China and India have become expensive, while the ”weak” economies such as Turkey and South Africa have become cheap. The cheap markets we are currently recommending are Korea, Brazil, Russia and Indonesia.


Could Russia avert a crisis in the unlikely scenario of a substantial and sustained drop in oil and gas prices? If not, how would the crisis unfold?
John Schneider, North Dakota

Michael Hartnett: Energy represents close to 60 per cent of the Russian equity market. So a severe and sustained drop in energy prices would have a very negative impact on the Russian market. It would be bad for the energy stocks and it would be damaging for the domestic demand story in Russia which is being largely financed by the high level of oil prices.


Considering the fact that a lot of companies in the emerging markets are growing annually at more than 30 per cent, in general what would you consider a safe P/E ratio to buy stocks at?
Mihir Goradia, Ireland

Michael Hartnett: Emerging markets are no longer cheap. Five years ago they traded at a 55 per cent discount to developed equity markets. That discount has now vanished and the asset class is more dependent on strong earnings growth for appreciation. When the growth of earnings slows the asset class is likely to come under pressure. The good news is that 2008 EPS forecasts are a realistic 15 per cent and that makes the 13-14X forward PE reasonable too.


What is Brazil’s relative position within the Bric group as far as mid and long term growth potential is concerned?
Joachim Riedel, Curitiba, Brazil

Michael Hartnett: Brazil is the slowest growing of the Bric countries in GDP terms in recent years but is the best performing equity market. The reason is that Brazil has been a cheap market boosted by a huge reduction in domestic interest rates and has been a favoured non-Asian play on China. So long as these drivers remain in place Brazil should outperform. But the performance has little to do with Brazil’s growth potential.


Many institutional investors already have exposure to emerging markets. If you think that the bull run of emerging markets would continue, which developed market would you underweight? Some of the emerging markets are becoming quite established. Is it not time to move on to frontier markets where market inefficiencies would give even better returns (with more risks)?
Peter Koh, Rome

Michael Hartnett: It is true institutional exposure to EM is rising. But it is likely to rise further given that many emerging markets remain highly undercapitalised relative to their GDP. The Bric markets for example still comprise just 4 per cent of the MSCI World index versus 44 per cent for the US. That share is likely to rise at the expense of the Anglo-Saxon markets.

We are also seeing great interest in the frontier markets like Vietnam and the Gulf states because these markets also have great growth potential but are much less correlated with the developed markets and the more established emerging markets.


To what extent is the emerging markets bull run a function of the global commodity bull run? Will emerging markets run out of steam when commodities go down, or is their something structurally different with this market?
David Josef

Michael Hartnett: The bull market in commodities has been central to the five-year emerging equity bull market. Almost one third of the EM index is energy and materials and over 40 per cent of the Bric index is commodity-related.

A bear market in commodities would imply weaker global growth and a reversal in EM current account surpluses, neither of which are EM-positive. Put another way, EM equities would then become highly dependent on the domestic demand story.


If the bubble in mainland China’s markets pops, do you think it will it pull other regional indexes down with it?
Adam Wolfe, New York

Michael Hartnett: Yes. A sharp decline in the China A-share market would have a temporary negative impact on regional bourses. But for a permanent negative impact the A-share market decline would need to damage Chinese growth prospects.


What will it take for emerging markets to reverse the current rally? How will a US recession impact emerging markets?
Mariano Colmenar, Madrid

Michael Hartnett: The current trading rally in emerging markets has been caused by stronger commodity prices, a weaker dollar and the liquidity boom in China. Reverse any of these and you will reverse the current rally.


Can the bull market in emerging markets continue? Which emerging markets will generate the highest returns? What is the outlook for the Bric markets? And should investors view emerging markets as a safe haven?
Dixon Chan, Hong Kong

Michael Hartnett: Can the emerging bull market continue? Yes. Will the leadership change? No. The risks to emerging market equity prices remain to the upside. An asset bubble seems likely, and it will be led by the Bric markets because that is where the domestic liquidity is most excessive.

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