Emerging markets seem to offer the best prospects for investment, but some observers are warning that rapid capital inflows and rising domestic spending in developing economies are signaling the next bubble.
The most obvious sign of a newly forming bubble is the huge run-up in prices of emerging-markets stocks. The MSCI Emerging Markets Index fell 64.5% from its high Oct. 31, 2007, to a low March 1. Year-to-date through last Thursday, it was up 63.3%.
The herd instinct that has in-vestors going into emerging markets “should make anyone nervous, because once the party is over, it is hard to get out the door,” Francis Scotland, director of global macro research at Brandywine Global Investment Management LLC, wrote in an e-mail.
In particular, a bubble in Chinese real estate and equity prices may be starting to form, he wrote in a report last month.
“Emerging markets have quickly gone from cheap to a lot closer to fair value,” said Michael Dicks, head of research at Barclays Wealth.
Barclays was overweighting emerging markets, “but now we're much more careful,” having moved to a neutral weighting, he said.
The risk, Mr. Dicks added, is that the momentum behind emerging-markets stocks could take the asset class well into overvalued territory.
In his report last month, Mr. Scotland said bubbles typically are fueled by easy-money policies, and bubbles often are triggered by policy responses to the previous bust.
In the current case, developing economies have stimulated domestic spending and credit growth as a substitute for the lost demand from the U.S. and Europe, Mr. Scotland said.
Policies in emerging markets have encouraged consumers to borrow and spend more.
Bubble prognosticators such as Mr. Scotland point to the growth in Chinese loans, which have been expanding by about 30% year-over-year in recent months. China has taken some steps to curb reckless lending, but it is under tremendous pressure to keep its economy growing — by stimulating credit — to head off domestic strife.
“[Chinese] authorities have stated that 8% [GDP] growth is the sort of number that is necessary to get sufficient trickle-down,” Mr. Dicks said.
And in many parts of Asia, property markets have been booming.
In Singapore, private-home prices rose 16% in the third quarter, from the previous three-month period, according to the Financial Times.
“Some [Asian] housing markets have stormed ahead,” Mr. Dicks said. “That's a fairly common story.”
Yet many observers still feel that emerging markets offer good long-term value, with the governments having learned lessons from the developed countries' debt-induced disasters.
Some of the large-cap stocks in the so-called BRIC nations of Brazil, Russia, India and China “are showing some signs of extended valuations, but other parts of the market, such as small-caps and frontier [nations], really haven't participated yet and look like decent values,” said David Halpert, managing member and chief investment officer of Prince Street Capital Management LLC, a hedge fund with $220 million under management.
Emerging-markets companies are “showing more growth in earnings than [companies in] the U.S., Japan or Europe,” Mr. Halpert said.
Some Chinese stocks may be “a bit frothy, [but] we don't think there's a bubble in emerging markets,” said Andrew Schiff, a broker and director of communications at Euro Pacific Capital Inc., which manages about $2 billion in assets.
“We still find very solid [Chinese] stocks at 12 to 14 times earnings, with 6% dividends,” Mr. Schiff said.
“With our own market up 50% over the last six months, you could also argue that that's a bubble,” said Benjamin Valore-Caplan, managing partner at Syntrinsic Investment Counsel LLC, which manages $450 million. That's why “I'd be wary in everything right now.”
But as part of an allocation plan, Mr. Valore-Caplan's clients have about 60% of their equity allocation in non-U.S. stocks and a “pretty decent allocation” to emerging--markets bonds, he said.
Meanwhile, Chinese policymakers have warned government-owned banks about making reckless loans. Such directives should work to some degree, analysts said, because Chinese bankers adhere closely to government directives.
Last week, the Reserve Bank of Australia raised interest rates a quarter point to 3.25% — a sign that Asian economies are doing relatively well.
Korea is widely expected to be the next country to raise rates, Mr. Hicks said.
The biggest unknown is how well emerging nations metamorphose their economies from dependence on exports to consumer-driven growth.
“The really big issue revolves around sustainability” of that transition, Mr. Hicks said. “It's a balancing act, [and] very easy to fall off that tightrope.”
If it's not managed well, China and other exporting nations will “gradually lose momentum, and their 8% and 9% growth rates become 5% or 4%,” he said.
Asian and Latin American countries still have a lot of political risk as they transition to consumer economies and attempt to meet the demands of their populations, Mr. Valore-Caplan said.
“Can repressive and corrupt regimes manage that?” he said.
E-mail Dan Jamieson at email@example.com.