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Capital Exits the First World In Search of Thriving Emerging Markets

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The strong performance of emerging markets is attracting increasing amounts of capital that used to be housed in the US.

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The emerging markets are melting up.

Year-to-date, it's the stock markets of some of the emerging economies that have enjoyed dramatic moves to the upper right hand corner of the chart: Indonesia (+38.2%), Chile (+34.4%), the Philippines (+34.3%), Thailand (+32.8%), and Peru (+26.1%).

Indeed, Philippine and Indonesian stock markets today again hit all-time record highs. The South Korean stock market is approaching its highest level since January 2008.

In contrast, citing exchange-traded funds as indicators, the U.S. stock market is just keeping its head above water: year-to-date, the SPDR S&P 500 (SPY) -- which includes holdings like Exxon (XOM), Apple (AAPL), Microsoft (MSFT), IBM (IBM), and Bank of America (BAC) – is up about 2%.

Jon Markman of Markman Capital Insight provides us with a graphic illustration of the divergence:



Investors have taken notice judging by mutual fund flows: year-to-date, they've now pulled $49.3 billion out of US equity funds, according to EPFR Global. Conversely, your friends and neighbors have committed $49.5 billion to emerging market equity funds.

What explains this emerging markets move?

Dr. Ed Yardeni of Yardeni Research cites two broad reasons. First, he says, global investors are searching for relatively pure plays on fast-rising commodity prices whether that's grains, coffee, cotton, or silver.

That run-up can be explained in part by speculators reacting to chatter about more money printing from the Fed. However, Yardeni argues that it has more to do with the latest batch of economic indicators suggesting that the global economy is growing rather than relapsing into recession.

So far in 2010, Tin is the biggest winner with an increase of 44.6%, well ahead of Silver (+28.3), Stainless Steel Scrap (24.8), Wheat (24.5), and Gold (20.2).

Another reason for the surge in emerging stock markets: investors are betting that rising wages in China will benefit the economies of China's neighbors. "I'm not sure that it is any more complicated than these simple observations suggest," the investment strategist recently told his clients.

Recent manufacturing surveys also paint an interesting global portrait of economic activity: for instance, the HSBC China Manufacturing PMI -- a key index of Chinese manufacturing activity -- jumped to its highest level in five months in September. Meanwhile, here in the US, the September ISM manufacturing index clocked in at 54.4, the lowest since November 2009.

Looking ahead, market pros cite near-term risks including the fact that the emerging markets trade is now getting crowded. The broader question is this, however: can these economies rock and roll even if developed economies sputter?

Dr. Gary Shilling, president of A. Gary Shilling & Company, believes that's a losing bet. Before the Great Recession proved them wrong, Shilling says, many argued that most foreign economies were decoupled from the US and would continue to grow even if America's economy weakened. Those convictions were dashed by the recession.

As Shilling recently argued to us, most foreign economies depend directly or indirectly on exports to the US to fuel growth and, with US consumers retrenching, those countries are in trouble.

But Richard Kang, chief investment officer at New York-based Emerging Global Advisors argues otherwise. He says that these nations understand that they can no longer count on American consumers and have adapted, trading more with each other and relying increasingly on domestic consumption.

It's why India has performed so well, he says. "The Indian economy has witnessed the benefits of decoupling," Kang notes. "Its companies truly cater to the Indian consumer." Year-to-date, Wisdom Tree India (EPI) is up 23%.

The secular theme remains intact, Kang says: the demographic and economic growth remains across the pond. By 2030, as he points out, 93% of the world's middle class will live in what is currently termed emerging markets.

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