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Risk Surges in Emerging Markets


Developing-nation shares most expensive since 2007.

Emerging markets, we're told, are the best bet for riding out the ongoing economic storm. Investors should therefore be afraid. Very afraid.

Since global equity markets swooned this March, stocks have staged an impressive rally. And even more impressive than the S&P 500's 43% gain, developing countries, as measured by the MSCI Emerging Market Index (EEM), have leapt more than 75%.

The outlook, however, remains cloudy. According to Bloomberg, emerging market shares are more expensive than they've been since 2007, as measured by their price-to-earnings ratio. The last time developing-economy stocks hit this level, they subsequently lost half their value.

With the developed world reeling from a wicked debt-inspired hangover, emerging markets have been widely viewed as a relatively safe bet on eventual economic recovery. This viewpoint is contrary to history, as stock markets in developing countries have traditionally been far more volatile than their more established neighbors.

This time, however, was supposed to be different.

Developing nations were in some sense better-positioned to handle a deflationary debt unwind of epic proportions: Their consumers are less dependent on debt to survive, as personal credit cards and home loans are far less prevalent than in the US. As credit markets froze up and the pipelines of free and easy debt went dry, consumers in Brazil, India, Peru, and Ghana could continue their cash-wielding ways with little interruption.

Furthermore, many developing economies rely heavily on commodity exports to bigger, wealthier nations. And even though oil, copper, and wheat prices have tumbled from last year's highs, persistent demand for these essential goods should buoy emerging markets -- even as a broader economic recovery remains elusive.

As evidence of the ongoing rebalancing of the the world economic scene, Petro China (PTR) has blown past Exxon (XOM) as the biggest company in the world by market capitalization. Indeed, 5 of the 10 biggest firms in the world now hail from China.

Lastly, as developing countries, well, develop, income disparities often narrow, as a new middle class evolves into a formidable consumer group. So even as the global economy contracts, individual counties can still grow as millions of people join the mainstream economy.

This is all well and good, but this isn't the first time investors have gotten a bit ahead of themselves with optimistic expectations for emerging markets -- in mid-2007 and in 2000. What followed in both instances was not something investors would care to repeat.

And despite great strides in the development of more robust capital markets, broadly more stable governments and inflation that has run less rampant than in the past (Zimbabwe, of course, notwithstanding) , emerging economies remain on shaky ground.

Many are reliant on just a few exports -- usually commodities -- to sustain growth, which leaves their economic fate at the whims of volatile markets for raw goods. Russia, Ecuador and Venezuela have all suffered as crude oil tumbled from it's highs last summer. These and other export-dependent countries still rely largely on bigger, more developed countries to buy their wares.

Latin America has rebounded from its debt crisis of the 1980s, but Argentina seems to be sliding back to its wayward ways and Ecuador, the Andean little brother of Hugo Chavez's Venezuela, recent defaulted on some of its sovereign debt, calling it "illegal."

It is no doubt that in the past 10 years, developing nations have been the leading engine for economic growth around the world (well, that and an historic debt bubble caused by reckless monetary policy and irresponsible borrowing in developed countries). And while it is certainly reasonable to expect these emerging economies to benefit as the United States, Europe and Japan rejigger their aging, bureaucracy-laden economies, to call them a safe harbor during turbulent economic times is borderline lunacy.

With potential reward comes risk. No matter how the global economic paradigm shifts in the coming years, this won't change.
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