Could emerging markets be heading for a collapse?

Developing markets reached a milestone this week. The MSCI Emerging Markets index regained the level reached on 12 September, when the bankruptcy of Lehman Brothers sent equities into a tailspin. Following a 50% drop, the index has almost doubled since October. India and Brazil have gained a respective 64% and 89% this year, while global investors poured a record $35.5bn into emerging market stock funds in the first half.

Developing countries have "emerged from the crisis with their underlying superior secular growth trend solidified in investors' minds", says Ian Scott of Nomura. Emerging market demographics and debt levels compare favourably with the West, giving them greater long-term growth potential, and their banking systems have largely avoided trouble. Lending growth has resumed in Asia and Latin America, and "this is helping drive growth", says Morgan Stanley's Michael Wang.

But investors are getting ahead of themselves. While domestic demand is set to increase in emerging economies over the longer term, the global outlook remains crucial for emerging markets overall, especially Asia. And "for all the enthusiasm about China's performance", the key variable here is America, and especially its consumers, as Marco Annunziata of Unicredit points out. And as its latest GDP figures confirmed, the consumer continues to retrench rather than go out and shop. With a feeble recovery in the offing, emerging markets look vulnerable to a renewed bout of risk aversion as investors realise that growth is set to disappoint particularly since emerging markets are hardly cheap.

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Socit Gnral warns that emerging markets' book value is now higher than the developed world's. "The last time that happened" (between mid-2006 and mid-2007) there was a "collapse" in emerging stocks. The MSCI index's p/e is back up to almost 18, the highest since the market peak of late 2007. Brazil's p/e is 23, a five-year high; China's bubbling market is at almost 40, while India, another popular bet, is also no longer cheap at 20. In reference to these last two, Goldmans Sachs' Jim O'Neill says: "wait for a correction".