Who will win the 2011 equity race: developed or emerging market stocks?

And... they are off. Developed (DM) and global emerging market (GEM) stocks are out the blocks in the race for best returns in 2011.

After a easy win in 2010, when the GEMs trouched the DMs returning multiples on DMs, most of the big names in the sport - China, Brazil and India - have tripped coming out of the blocks at the start of this year.

GEMs took in over $100bn in 2010 of fresh money, but some $13bn flooded out again in the first month of this year on the back of rising fears that spiking inflation will derail the GEM story.

For the first time in about a decade DMs have outperformed the GEMs: the MSCI World Index, a widely followed proxy for the globe's markets, have rallied 6.2% while the MSCI Emerging Market's index was up by only 2.8%.

Pundits have been pointing to the better than expected economic performance of the DMs and there has been a flight to "quality", but what is really happening is a correction of overshoots.

As the DMs are so obviously screwed by their horrible debt and deficit positions, while most GEMs are back to double-digit growth, the emerging markets have become hot and so much hot money flooded into these markets that central banks in some, like Brazil and Turkey, have been forced to put up administrative barriers and capital controls to keep the unwanted liquidity out.

The result of this influx, sourced in part from America's decision to release another $600bn of quantitative easing (QE2) in November, has sent inflation soaring around the world, a problem made worse by the return of the food price crisis from 2008 that was temporarily suspended by the financial crisis that started that autumn.

Investors have begun to sell GEM stocks as they are clearly getting expensive. However, they are starting to buy DM assets as they have clearly gotten too cheap after being ignored for nearly two years.

The mainstream media has been having fun with the inflation story, as the rapidly rising inflation rates are clear to all. However, listen closely as after identifying the trend they go on to promise that they will explore the "ramifications" and never do.

HSBC release a note on February 18 saying that DMs won't beat GEMs this year, "because the valuation of the MSCI Emerging Markets Index has become too attractive to pass up."

HSBC's Hong Kong-based equity strategist Garry Evans, said: "We remain comfortable that GEM will outperform DM during 2011. While it is possible that GEM might continue to underperform for a little longer, it is highly unlikely to do so for the year as a whole. We fail to find a reason why the long-term structural outperformance of the EM universe should not continue."

Of all the GEMs, Russia has done best, mainly as it missed out on the rally in 2010: Russia alone took in new money - and was continuing to take in new money in the first two weeks of February, as its stocks caught up with the other GEMs.

Moreover, while industry in China and India is approaching full capacity and talk of "overheating" has started, capacity utilization in Russia remains at about 60% so it still has plenty of growing room, before the economy starts to heat up and inflation becomes a real problem.

These large flows of hot money and the herd mentality that goes with it are the aftershock ripples from the crisis. Huge amounts of money flooded into GEMs in the second half of 2009 (including Russia), less in 2010 (none into Russia) and now some will flooding out again as the wave recedes in the first half of this year. However, the structural problems in the west remain while growth will clearly be much higher in the east than it is in the west for the foreseeable future. And as every school boy knows water always flows from high to low.

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