Six months ago, the bullish consensus on emerging markets among investment bank strategists and 'celebrity' investors like Jim Rogers was overwhelming, despite historically high valuations relative to developed markets. They would decouple from the credit crunch fallout and prove a safe haven for US investors seeking to diversify their equity exposure.

Oops. Since the high last Autumn, the MSCI Emerging Markets index is down 23.6% against 19.5% for the S&P 500. The much hyped BRIC markets, focus of many new fund launches last year, have slumped further than most developed markets. China is down 54%, India 35%, Brazil 18% with only resource heavy Russia outperforming with a 14% decline. They have all still had a tremendous run since 2003, but the bulls extrapolating those returns into 2008 missed one crucial issue; inflation. Six months ago, only 24 percent of the respondents to Merrill's institutional investor survey were overweight U.S. stocks versus 53 percent who favored emerging markets.

In a total reversal of sentiment, the latest numbers inverted to 40 percent and 30 percent, respectively. I guess that's why they call it active fund management. State Street has announced that foreign investor outflows from emerging markets have soared in the past few months, exacerbating the downtrend. Back in May, I advised selling the rally in emerging markets in Will inflation slay the emerging market bull? as 'many emerging markets such as India are still in denial as to the painful trade off between growth and inflation they now face'. We currently have inflation hitting 15% in Russia, 25% in Vietnam, 12% in India and 8% in China, in all cases well above fast rising local interest rates, implying further monetary tightening and slowing domestic growth is inevitable. In all, 50 countries globally now suffer double digit inflation; most emerging market economies are facing overheating and macroeconomic instability, and the latest IMF growth forecasts look way too optimistic to me.

So far in the sell-off, the commodity exporters (Russia and Brazil) have outperformed the importers like India and China, whose terms of trade have deteriorated dramatically, driving imported inflation. If, as I suspect, oil and other commodities slide in the second half (soft commodities are down 16% from their March peak; food is the biggest driver in Asian inflation), that relative performance will reverse.

China (FXI) at 20x reported earnings, and India (EPI) at 14x are beginning to look reasonable value for long term investors and would certainly participate in a Summer bear rally for equities worldwide. However, I'm bearish against consensus for Chinese GDP growth and there is a risk of a major currency revaluation forced by speculative liquidity flooding through the surging current account. Indeed, macro stability will be key to safely return to these markets, in terms of managing both inflation and currency expectations. Look for stabilizing inflation data and a growing bearish consensus from trend chasing investment banks as a signal to build positions later this year. And as a wise rule of thumb, when you see an investment 'consensus', focus on the first three letters of that dangerous word...

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Sean Maher

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