Emerging market asset bubble unlikely to burst soon

Emerging market asset bubble unlikely to burst soon

New York: Little more than a year after global financial markets collapsed after the US housing bubble burst, developing countries are giving birth to a new asset bubble -- one that investors bet will keep growing for some time.

Cash has been flooding emerging markets since March as investors in pursuit of strong returns see countries such as China and Brazil leading global growth in the next few years, while developed world economies remain nearly stagnant.

Those capital flows, which have been super-sized by the ample liquidity measures taken by central banks to fight the crisis, have lifted emerging market stocks more than 70% so far this year, according to the benchmark MSCI stock index.

In Latin America, stock prices have soared over 90% this year on the MSCI while currencies like the Brazilian real gained more than 30%.

And even though most of the gains simply account for a rebound from last year’s meltdown, some investors predict the rally is just starting, with only short-term corrections coming along the way.

“I think there may be a bubble forming in some emerging market stocks, not just in Latin America, you see the same kind of pattern in Asia," Standard & Poor’s chief economist David Wyss said.

“There is just a lot of cash looking for yield and not quite believing that you can’t get 19% a year anymore," he said, referring to the average returns of the S&P 500 during the 1980s and the 1990s.

Jeremy Grantham, co-founder and chief investment strategist of money manager GMO, forecast that the premium over earnings that investors pay for stocks in some emerging markets could reach 50% in coming years, as those countries have "the people, the savings and the attitude" to convey a compelling growth story.

Currently, emerging market stocks trade on average at a 13.6% premium of price to earnings, according to estimates from Thomson Reuters’ StarMine.

“On a dividend discount model, emerging is already overpriced," Grantham said. “But it has an appealing story that will transcend its value limitations. In other words, it will have a bubble."

Fast Living

Governments in many developing countries have already expressed concern about the magnitude of capital inflows, which they see as a threat to exporters due to the currency appreciation.

But attempts to reduce those inflows have proved ineffective so far. A 2% tax on foreign capital imposed by Brazil earlier this week brought only temporary losses to the Bovespa stock index and the real .

The Brazilian benchmark stock index is still up some 75% so far this year and some analysts see it rising another 15% by the end of the first quarter of 2010.

Underscoring the huge appetite for emerging markets, stock funds dedicated to the asset class saw enough inflows this year to recover all of their 2008 redemptions and beat the record inflows of 2007, according to EPFR Global.

Investors seem unlikely to back off from emerging markets any time soon.

“Allocations to equities and emerging markets have risen, but remain well off the highs seen this decade. A ’bubble’ may yet emerge in Asian asset prices, but it is premature to consider a bursting of one," UBS economist Larry Hatheway said in a research note.

GMO’s Grantham, who said he thinks a new bubble “will suck in the money and it will go higher and higher," said he remains overweight in emerging markets, even though it is becoming increasingly difficult for value-focused managers to justify current valuations.

“It’s about time, if you play the numbers pure value, to start pulling back from emerging," he said. “But if you want to live a little bit fast and loose, I think it’s going to go up."