Can emerging markets avoid a correction?

The emerging-market equity boom, fuelled by US retail investors, has seen India, South Korea and, above all, China, outperform most developed markets. But with the recent recent Chinese rate hike following warnings that the current rate of growth was 'unsustainable', could the emerging markets be heading for a correction?

People who have been invested in emerging market equities over the last couple of years have had more reason to celebrate than most. Asia in particular has been the investment story, but India, China and, to a lesser extent, South Korea have outperformed most developed markets, says Money Management. And it's all down to China again. The "Asia express" is being driven by the Chinese, who opened up their domestic markets as recently as 2001 when China became a fully fledged member of the World Trade Organisation. But now its pace of economic growth is so dynamic that the World Bank estimates its share of the world economy will triple over the next 20 years, putting it on a par with the US as an "economic powerhouse". The increasing affluence of the world's most populous country is behind the positive performance of other countries in the region.

That's the theory but it still needs buyers to push the markets up. So who is behind the inflows? US investors, it would seem. They have "poured" $68bn into international mutual funds so far this year more than twice the amount put into US funds. Europe and the UK have both been beneficiaries of this wall of money, but emerging markets, such as South Korea, India, Russia, Brazil and Turkey have also been major targets, says Deborah Brewster in the FT. Fund tracker TrimTabs points to the extent to which US retail investors are "fuelling" the boom in emerging-market equities. Last year, Americans invested about $130bn in foreign funds three times the amount they invested in US funds. This year, the rate has slowed slightly to a 2:1 ratio, according to the latest estimate to 19 April, but it's still "very high" by historical norms. During the US boom years of the 1990s, most US investors put far less than the 10%-12% of their assets currently recommended by advisers into overseas markets, but now 70% of their new money is going abroad and some brokers even recommend investors allocate 25% of their total funds abroad. Add in another $10bn a month from institutions, hedge funds and commodity funds and it's easy to see why these markets are going up.

Why are US investors so keen? Charles Biderman, TrimTab's chief executive, believes it is because they are concerned about the pace of US economic growth. The worry, though, is that investors are only choosing the areas that have done well in recent years and that inflows as big as this usually signal the top of that market. Devotees of this view will have noted the sharp falls in global equity and commodity markets last week after the Chinese authorities raised interest rates for the first time in 18 months. Beijing recently raised its benchmark one-year lending rate from 5.58% to 5.85% in the wake of a warning that the country "may not be able to sustain" its fast pace of growth, says Edmund Conway in The Daily Telegraph. And markets were only rescued when Federal Reserve chairman Ben Bernanke indicated that the Fed may soon pause its two-year campaign of interest-rate increases.

It is too early to say whether the Fed has managed to engineer yet another great escape for the emerging markets, but Citigroup analyst Andrew Howell says it's doing the job at the moment. There are two "fundamental forces" conspiring to push these markets higher, he says. On the one hand, commodity prices have maintained their "adrenaline-fuelled vigour", and on the other hand the Fed is succeeding in reassuring market observers that the end of monetary tightening in the US is "nigh". The last word goes to Jim O'Neill, chief economist at Goldman Sachs and inventor of the term BRIC' to describe the fast-growth Brazilian, Russian, Indian and Chinese economies, who says that while there is "no way" the Chinese rate hike will stop economic growth over the long term, it could mean a correction.

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