03/02/2011 10:39 am ET Updated May 25, 2011

Are Emerging Markets the Next "Bubble"? How to Overcome the Issues

We're well aware of the case for investing in Emerging Markets. However, investor excitement is ignoring the fact that short-term cyclical factors can overshadow long-term structural trends. By this I mean valuation, inflation and allocation. In addition, as we know, "love can be blind" and in jumping on the bandwagon many are not getting the exposure they expect. Is too much optimism fuelling a "bubble" and does the risk of disappointment represent the potential for it to burst?

Weakness in the West, Cast Eyes East

With consumption weak in the West, many look to the East to pick up the slack and drive global growth. An estimated 1 billion are to join the consumer class by 2030, with the Chinese middle class to exceed the entire current US population within a few years. We've seen an impressive resolve, industrial production is already above its pre-crisis peak and resilience is growing as levels of intra-regional trade continue to increase fuelling the argument that these markets will be less affected by pullbacks from developed market demand and instead driven by domestic demand.

Acronym Over-Exuberance

The onslaught of phrases generated by the investment banks to entice people to invest has been impressive. 'BRIC', 'Chindonesia', 'CIVETS' and now the 'Next 11', the list continues. But crucially we are learning that a pithy abbreviation does not necessarily equate to a profitable investment. In 2010, US equities significantly outperformed Chinese, despite far weaker GDP grpwth numbers. The focus isn't on the absolute figures but how they compare to expectations. Is it now worrying that the consensus for China's long term earnings growth is forecasted at 18%? Not much room is left for upside surprises, but there's plenty of space for disappointment! A rally of ~135% since the market low of 2008 by the MSCI EM Index places Emerging Market stocks at stretched valuations, for which a pullback would be healthy.

Inflation Impact

The main issue which could cause this pullback is inflation. I mentioned this in my last post but to highlight the risk -- official Chinese figures measure inflation around the 4.6% level whereas anecdotally they have been experienced at 20%! Inhabitants of Emerging Markets spend twice as much of their money on food than in the G20 and with agriculture prices reaching all time highs, food price increases will only become more important. However, China, as of the beginning of the year, is reducing the contribution of food to their calculation of inflation. This all emphasises the potential for shocks further down the lines when figures do not meet expectations, in addition to the downside potential to growth when inflation reducing policies are implemented is significant.

The "Tap" has Been Turned

Exacerbating the issue is the high level of allocations to the region. A record percentage of portfolio managers are overweight Emerging Market equities. The combined net assets of the two largest EM ETFs are now above that for the S&P 500, despite the US equity market being ~4 times the size of the investable EM universe. We have started to see outflows. This year so far, during one week alone, $7bn was withdrawn from these markets.

Interest Misalignment

With only 14% of EM market cap represented by domestic-facing sectors, the majority of stocks do not give investors exposure to the rise of the Consumer and the "Domestic Demand" growth story, the main reason for investment. In addition, government ownership can be significant (67% of market cap in China vs 3.7% in the US, at the height of the financial crisis, government ownership was about 3.7% of market cap. A majority government owned entity may at times not act entirely in the interests of the investors.

So What Can We Do? The Investment Insight

Don't get swept up in the over-exhuberance. Remain focused on the issues, question assumptions and challenge government published figures. Differentiate within regions, countries and sectors, and get to know the companies you're investing in...