In a world that is awash with liquidity (a function of loose global monetary expansion and a rich Middle East), emerging markets have witnessed increased inflows both in terms of foreign direct investment and foreign institutional investment. Hence stock markets have rallied in recent years as foreign money has continued to feed the buying frenzy. With growing foreign interest in uncorrelated emerging African markets, Mauritius too has not been alien to this global trend as net foreign purchases on our blue chip stocks have remained strong throughout the year. Following the August 50bps Fed rate cut, inflows into emerging economies have remained strong with more than USD33bn being invested in the space of two months. With such inflows, emerging markets have continued to reach new heights but are all these inflows justified or are emerging markets now overvalued?

Traditionally, foreign inflows and earnings growth go hand in hand. Investors have invested in emerging markets because they believe in the long term growth potential of emerging economies; this is after all the century of the BRIC!

<B>Appreciation of the Indian rupee</B>

However, with so much excess liquidity in the world, investors will need to be more careful because there are already cases where divergence has occurred between stock price growth and earnings growth.

This is particularly true for India?s BSE SENSEX, which is currently trading at a PE that is almost three times higher than expected earnings growth. Out of the USD33bn that has flowed into emerging markets since the Fed rate cut, India has attracted more than USD 7bn in foreign inflows (USD 18Bn so far this year). Even the recent SEBI decision to regulate foreign inflows through P-notes has not stopped the SENSEX from crossing the 20 000 mark. Large foreign inflows have not only caused the Indian rupee to appreciate by more than 10% this year (thereby impacting exporters) but have also made India become the 6th largest holder of foreign reserves in the world. The Reserve Bank of India is likely to lower rates later on this year but political realities in India and rising food prices will constrain its move.

Many analysts have also been warning against investing in the Chinese market in recent years. If one were to sum up all the market caps of the mainland, Chinese stock markets are currently trading at more than a 30% premium to the country?s gross domestic product (GDP). In a country that is still facing internal pressure to raise interest rates in order to combat inflation and where accounting standards for many companies remain murky (and add to that a still fragile banking system), investors should exercise caution.

However, investors should not generalize, there is still great value to be found in many emerging economies and overall earnings growth is expected to remain strong. Even within India, infrastructure funds offer great value in the longer term. The Mid East and Africa region, one of the centres of global excess liquidity, offers great value and so does Asia. Mauritian mutual funds and pension funds will need to analyze emerging markets more deeply and adopt varying strategies for different regions in order to find good returns. No longer will traditional MSCI Emerging markets type funds deliver the same performance seen in recent years and hence more research will need to be done before selecting a particular fund.

<B>Continued growth</B>

Local investors will have to understand that emerging markets (of which Mauritius is a part) will need to form part of a diversified portfolio that is held for a three to five year investment horizon. With interest rates in Europe likely to remain on hold in the coming months and with the Fed likely to cut rates by another 25bps soon, global monetary growth is expected to hover above global nominal GDP growth thereby creating even more excess liquidity in the medium term.

Furthermore with rising oil prices, GCC economies will continue to add to the global liquidity kitty and emerging markets are likely to witness continued growth. In sum, while emerging markets are likely to outperform developed markets in the coming years, fund managers will need to play a much more proactive role when deciding on asset allocation in order to provide a satisfactory return stream in line with the risk (and hence the required rate of return on equity) of investing in such markets.

<B>Contributed by INVESTMENT PROFESSIONALS LTD </B> (Feedback: [email protected])