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Emerging markets have had their day - for now Add to ...

While investors suffered through a lost decade in most U.S. stocks, they found gold in emerging markets.

In six of the eight years from 2002 to 2009, the MSCI Emerging Markets index was the world's best-performing financial asset class, according to Callan Associates, a San Francisco-based investment consulting firm.

We all know why: Emerging markets grew rapidly as exports thrived. With their stronger finances and faster gross domestic product growth, they were a much better investment than the debt-ridden, stagnant developed world, including the good old USA.

The MSCI emerging markets index added 13.2 per cent annually in the 10 years from 2001 through 2010, while the Standard & Poor's 500 index barely broke even.

But nothing is forever in global markets, and we may be seeing one of those periodic turns of the wheel.

Bangkok, We Have a Problem

Last year, the Wilshire 5000 advanced 17.2 per cent, topping emerging markets' 16.4 per cent gain. The U.S. market's victory was paced by the stellar performance of small-cap growth stocks, the market's newest hot spot.

And 2011 has so far been a disaster for some of the world's most stellar performers. Emerging market exchange traded funds are "breaking down like crazy," reports Nicholas Vardy, chief investment officer of London-based Global Guru Capital and writer of the Global Stock Investor newsletter. "They literally are just running out of gas."

Vardy says that in the last few weeks he's dumped stocks and ETFs from markets such as Indonesia, Turkey, Chile, Colombia, Thailand - five of the best stock markets in the world in 2010. "They are all down 20-22-23 per cent," he tells me.

They may have further to fall, too - and not just as part of a "healthy" correction. Because inflation is back, particularly in the world's fastest growing economies.

Just look at the numbers: Brazil, 7.6 per cent; India, 8.4 per cent; China, 5.1 per cent, and Indonesia, more than 6 per cent.

Rising Prices, Rising Currencies

"Headline" inflation includes volatile food and energy prices, which have been soaring because of strong global demand and unusual weather patterns. Copper, cotton, and grains have hit multi-year highs in recent weeks.

These prices do fluctuate more than those that comprise "core" inflation. But growing demand for food, fuel, and commodities from emerging economies - not to mention recovering developed countries - will keep both headline and core inflation higher over the coming months.

And it will hit emerging markets hardest. They're facing rising wages as well as higher materials costs - bad, bad news for companies trying to maintain profitability without pricing themselves out of the market.

The Federal Reserve's loose monetary policy isn't helping, either. "Hot money" is flowing into these markets, raising pressure on prices and driving up the value of many emerging currencies.

The Brazilian real has soared almost 40 per cent from its low, the South African rand has jumped nearly 50 per cent, and currencies from Colombia, Chile, Indonesia, and South Korea have risen by 20 per cent and more.

That will hurt exports, ultimately slowing these countries' economic growth. It's just a bad combination.

Experience Tells - And So Does Lack of It

It's such a bad combination that Stephen Roach, non-executive chairman of Asia for Morgan Stanley and teacher at the Yale School of Management, is worried that central bankers of emerging countries haven't come to grips with the problem.

"The inflation rate is up for headline inflation and underlying core inflation," he tells me. "The latter is key, because policy makers in the developing world felt that post-crisis headwinds [would]keep core rates under control."

That hasn't happened. As of Nov. 2010, he says, core inflation in Asia except for Japan was 4 per cent, and headline inflation was 5.3 per cent. "All those numbers are up 1, 1.5 [percentage points]compared to late 2009." That's a huge jump in one year.

Roach, who toiled as a Fed economist during the inflationary 1970s here, is particularly sensitive to the relationship between core and headline inflation. "The lesson from the 1970s is the interplay between these are really important. You don't want to wait too long," he warns.

So, how are emerging market central bankers handling it? Not so well, he says.

"Central bankers are behind the curve - in China, India, a little bit in Korea, Indonesia, Singapore. We're closer to the beginning [of tightening] than the end," he adds.

And although he doesn't forecast stock market returns, he observes: "The markets are anticipating already that … a fairly significant tightening [is] going to unfold over the next few months."

In for the Long Haul, or Not at All

Hmm, rising inflation followed by higher interest rates? Sounds like a repeat of the 1970s, a "lost decade" if there ever was one, although the latest round is likely to hit emerging markets a lot harder than it will hit us.

In fact, Mr. BRIC himself, Jim O'Neill, chairman of Goldman Sachs Asset Management, is slightly more bullish on U.S. stocks than on his beloved emerging markets. In a commentary in the Financial Times last week, he predicted stronger-than-expected annual U.S. GDP growth of 3 per cent to 4 per cent over the next couple of years.

"The U.S. market might continue to outperform so-called emerging markets for a while, although that will not last," he wrote.

Unfortunately, U.S. retail investors may not have gotten the word. Emerging markets have been virtually the only game in town for them for the last couple of years.

According to the Investment Company Institute, U.S. investors poured $24.4-billion (U.S.) into emerging markets equity funds last year and another $16.9-billion in 2009, while unloading more than $120-billion in domestic equity funds during that time.

So, could they have come to the party just as it's ending?

To be sure, these markets have a lot going for them, and their long-term prospects are certainly better than those of Old Europe or stagnant Japan (except for, say, Germany or Scandinavia). The balance of power in the world is changing, and over time investors will shift their portfolios to reflect the faster growth and greater clout of these emerging powers.

But inflation is a real problem, and their central banks may need to raise rates much higher and a lot more quickly than most pundits expect. That's why some of the savviest holders of the highest-flying emerging-market ETFs have been taking their chips off the table.

Will performance-chasing retail investors be left holding the bag yet again? Not if they stay in the game for the long haul. And I sincerely hope that people who loaded up on emerging markets during their salad days didn't make them too big a part of their holdings.

***

The following ETFs represent some of the countries mentioned in this column:

MarketVectors Indonesia Index

iShares MSCI Turkey Investable Market Index

iShares MSCI Chile Investable Market Index



Howard R. Gold is a columnist for MarketWatch and editor-at-large for MoneyShow.com.



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