Emerging markets. Will the party run out of punch?

• Author: Hermitte, Riccardo Barbieri

The emerging markets have been enjoying a powerful mix of accelerating world economic growth, high oil and commodity prices, a weak dollar, and extremely low US interest rates. Monetary policies in the industrialized countries remain unusually accommodative despite real global GDP growth in 2004 that we expect to be the second highest of the past ten years. Emerging markets are facing two critical issues, however--rich valuations and the Fed's "exit strategy" from 1% interest rates. Since skepticism lingers about the sustainability of the world recovery, the Fed seems to be the biggest concern, as investors fear that the party can only last until Alan Greenspan takes away the punch bowl. We beg to differ.

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It's all about growth. The investment case for emerging markets hinges on economic growth and on institutional and political convergence with developed markets. We see much evidence of convergence: China's and India's increased involvement in world trade for goods and services, successful political transitions in Brazil and Turkey, Russia's fiscal consolidation, and the emerging world's growing reliance on flexible exchange rates and decreasing dependence on capital inflows.

Growth is the necessary condition for these transformations to be sustainable, and we expect global GDP to surprise on the upside. Despite the efforts of the Chinese authorities to slow the economy, we estimate that developing and transition economies will grow faster than the advanced countries in 2004 by 2.5 and 1.5 percentage points, respectively. Economic performance across regions should also exhibit a lower variance than in 2003, thanks in particular to a recovery in Latin America.

Granted, emerging markets face risks. Valuations are already above historical norms in certain emerging credit and equity markets. Asian growth could ultimately boost prices of intermediate goods and global inflation above the low expectations priced into the bond markets. Even in a scenario of still-moderate but rising inflation, US bond yields will probably go up over the course of this...