Emerging Pitfalls

Sizzling markets in developing countries look even riskier

Somewhere in the Communist afterlife, Lenin opens his morning Pravda to learn the Russian stock market has jumped by almost 3,000% in the past eight years. Down the hall, Mao Zedong spills his green tea upon hearing of the Shanghai exchange's 130% surge in 2006 and the world- record $22 billion initial public offering for Industrial & Commercial Bank of China. Ho Chi Minh, meanwhile, recoils in horror (though he still yearns for a CNBC feed) after reading that Vietnam's stock index more than doubled in 2006.

The comrades might well shudder, but today's capitalists sure like the Communists' old haunts. Since 2003, stocks in developing economies have averaged gains of 30% annually, blowing away shares from less exotic locales. With the Mexican, Asian, and Russian meltdowns of the 1990s long forgotten, developing-country stocks keep jumping to all-time highs. Over the past five years, emerging-markets mutual funds have delivered four times the average annual returns of diversified U.S. stock funds, according to investment research firm Lipper Inc.


And for good reason. Developing markets, historically the province of hyperinflation and parliamentary donnybrooks, now enjoy brimming surpluses, thanks to record commodity prices and newfound fiscal discipline. Since 2001 these economies have posted three times the average annual per-capita economic growth of their developed counterparts and now represent a quarter of global output. Stocks in emerging markets are "the last bit of semi-genuine excitement in the business," says Jeremy Grantham, the famously cautious chairman of GMO, a $127 billion investment management firm in Boston.

Too much excitement, though, invites peril. Emerging markets have undeniably changed in the past decade, but lately they're looking overextended--so any hiccup could send them tumbling. And while the potential triggers for a fall have changed, they're still there. As economies in the developing world get stronger, governments are getting more assertive and meddling with both companies and neighboring countries, increasing political risk. The money flowing in, meanwhile, has boosted some currencies to levels that could threaten growth. If any of these were to spook investors, the rush for the exits could mean an unprecedented collapse.

That's because there has never been so much cash sloshing into emerging equities. In the 12 months through November, 7% of all U.S. money invested in mutual funds went to emerging markets, up from 0.38% in 2000, according to Citigroup Investment Research. And as individual investors mail in their retirement-fund checks in January, many expect the numbers to keep climbing. "People are saying, `I missed emerging markets for five years in a row. That's it, I'm in,'" says Donald Elefson, portfolio manager of the $1.1 billion Excelsior Emerging Markets (UMEMX ) fund.

The record slim yields offered by emerging-market bonds have pushed even more money into stocks. Four years ago, bonds issued by developing countries paid about 10 percentage points more than U.S. Treasuries did. Today, the difference has fallen to less than two points as governments have used commodity windfalls to pay off loans. Investors "are spilling over into emerging-market equities that have traditionally been out of their comfort zone," says Christian Stracke, an analyst at bond researcher CreditSights.

A meltdown almost happened last June. Yields on 10-year Treasury notes hit a four-year high of 5.22%, raising fears of inflation and curbing investors' appetite for risk. Russian and Turkish stocks took a 30% haircut. Ditto Bombay's white-hot Sensex Index, whose plunge had police on the lookout for investor suicides. On average, bourses in emerging markets declined by 26% in four weeks; the $20 billion pulled out in the second quarter equaled 20 months of money coming in the door. Sure, those markets roared back when Treasury yields came down, but the plunge gave investors a painful lesson in the volatility that accompanies so much eager money. "There is a lot of froth," says Andrew T. Foster, director of research at Matthews Asian Funds.

The Sensex has recovered, but India is still having a hard time digesting the cash flowing in. In December, the State Bank of India tried to curb runaway borrowing and rising wages with a half-point rate hike, sending stocks tumbling 7% in three days. "The inflation rate, the current-account deficit, property prices, and credit quality have already reached worrying levels," says Ridham Desai, joint head of research for JM Morgan Stanley Securities in Mumbai. "Policymakers' abilities [are] limited."

Options are especially restricted for countries that compete with China. Beijing has continued to keep the yuan artificially low despite the money flooding into mainland markets. Smaller neighbors have seen their exports take a hit as hot money has pushed their currencies higher. That has led to some desperate measures. To stem the baht's steep rise, for instance, Bangkok on Dec. 19 announced rules making it harder for investors to take cash out of the country. Thailand's stock market plunged 15% in one day, and emerging-market indexes the world over sold off in sympathy.


Although most bourses quickly bounced back when Thailand canceled the plan, other countries might still consider capital controls. Indonesia's market jumped 60% last year, helping send the rupiah 7% higher against the dollar. And South Korea, Asia's No.3 economy, saw the won rise 9% against the greenback in 2006. Since Korea represents an outsize chunk of the benchmark Morgan Stanley (MS ) Capital International emerging-markets index, any currency intervention in Seoul could inspire a global sell-off.

Political turmoil elsewhere could be just as devastating. Nations that were perennial economic underdogs now have more economic muscle. Venezuela's Hugo Chávez, for instance, is parlaying oil wealth into a sphere of influence in Latin America. Chávez has shored up Havana and funded victorious leftist politicians in Bolivia and Ecuador. And by buying bonds from Argentina--a credit-markets pariah since it defaulted on international loans five years ago--he has sheltered Buenos Aires from angry creditors and helped stocks there jump tenfold since 2001. Chávez' growing influence means that a collapse in Caracas could take much of the continent down with it. These manipulations "make the market vulnerable to a pullback," says Walter Molano, partner with Greenwich (Conn.) investment bank BCP Securities.

Even more worrisome might be oil-flush Russia. The Soviet-style killings of ex-spy Alexander Litvinenko and others have raised fears of growing lawlessness. And Gazprom's shakedown of foreign oil companies looks like a creeping effort to reestablish state control of the energy sector. Nonetheless, investors love the place, sending stocks on the Moscow bourse up by 65% in 2006. "In my 10 years in Russia, I have never seen such systematically negative coverage in the Western press and such enthusiasm by the financial community for all Russian assets," says Eric Kraus, manager of the Nikitsky Russia/CIS Opportunities Fund in Moscow. "There is a total disconnect at this point."

By Roben Farzad, with Jason Bush in Moscow, Cristina Lindblad in New York, and Nandini Lakshman in Mumbai

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