Emerging markets make it four in a row

It's been another sizzling year for emerging market equities. Despite a rapid 25% slide in the spring, prompted by jitters over higher global interest rates which typically reduce the appeal of riskier assets stocks subsequently bounced back to a record high. The broad MSCI Emerging Markets index gained 26% this year in dollar terms, making 2006 a fourth successive up year for the asset class. MSCI indices tracking eastern Europe and Latin America have gained 42% and 37% respectively, while the MSCI Emerging Asia index has climbed by 26%. Investors have been encouraged by a robust global growth outlook and structural improvements in emerging markets, notably tamed inflation, high foreign exchange reserves and the appearance of middle-class consumers.

Emerging markets: the top performers in 2006

As far as the top-performing individual markets are concerned, it's the usual story, says Frederik Balfour in BusinessWeek: "exotic locales" with small, relatively illiquid markets delivered the best returns. Peru's Lima General Index topped this year's table, rocketing by 190% this year in dollar terms as exports of copper, gold and natural gas underpinned GDP growth of 7.5%. Buoyant oil revenues boosted Venezuela. Vietnam, Asia's other Communist dynamo, finished second with a jump of more than 150%, and there is plenty of scope for further gains over the long term. Vietnam is "one of the few genuine competitors to China, offering cheaper labour costs", notes New Star, while foreign investment is set to rise further.

China notched up the best run by a major market. The Shanghai index has more than doubled, thanks to a series of market reforms that allayed concerns over corporate governance and non-tradeable government stock; it has begun to reflect confidence in China's prospects. Another theme emerging from the top ten is the ongoing convergence of eastern Europe with the EU or mounting confidence following EU entry, as has been the case in Cyprus.

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The prospect of EU membership next year has propelled Bulgaria's GDP growth to a record 6.7%. Emerging Europe still offers "particularly healthy growth prospects", according to New Star, while emerging markets guru Mark Mobius has upped his Templeton Emerging Markets Investment Trust's Russian exposure to 7.9% from 5.3% as firm oil prices bode well for the market. Indonesia, Asia's second-best performer this year, finishing 11th, is benefiting from strong domestic demand and the prospect of investments in infrastructure, although the market is no longer cheap on a p/e of 18. Another market whose potential MoneyWeek has repeatedly highlighted is India, which finished just outside of the top ten with a dollar gain of 43%.

Merrill Lynch points out that some of 2005's top performers finished near the bottom of the table this year, a reminder of how quickly liquidity can rotate out of small developing markets. The burst bubble in the Gulf ensured that these markets limped home last in 2006.

Meanwhile, one market looking unlikely to attract much liquidity any time soon is Thailand, Asia's worst performer in 2006. The SET index plunged this week as the military government imposed capital controls on foreign equity investors; the rattled authorities promptly performed a U-turn. Meanwhile, the market is cheap, but the post-coup uncertainty threatens growth and interest rate cuts are overdue, as CLSA's Christopher Wood notes. "Thailand will become a great value buy one day", but just not now.