‘Monstrous risks’ in emerging markets

(Reuters): Emerging markets face “monstrous” risks this year, with investors continually ignoring intensifying inflationary pressures and credit bubbles, leading market strategist Richard Bernstein warned on Wednesday.

Emerging markets have been the darling of the financial world since 2009, as global investors have pursued stronger returns and driven by a belief that countries such as China and Brazil will lead global growth in the next few years, while developed world economies remain nearly stagnant.

Bernstein, who now runs his own firm after being chief investment strategist for Merrill Lynch & Co, said the love affair with emerging markets is overdone. “I think what people are completely missing is that the risk is not here in the United States,” he told the Reuters 2011 Investment Outlook Summit. “The risk is in emerging markets. There are just monstrous risks in emerging markets right now in my opinion.”

Red flags are mounting

Brazil’s and India’s government yield curves are inverting, a condition in which short-term rates rise above longer yields. Historically, such an inversion almost invariably precedes a recession, as investors temporarily accept lower long rates in anticipation of the decline in yields that typically accompanies an economic downturn.

Also, China’s economy is slowing quickly from its double-digit pace, as authorities there have adopted policy tightening measures. So far this year, the MSCI Emerging Market equity index is down 0.6 percent after rising 16.4 percent in 2010 and jumping 74.5 percent in 2009.

Bernstein is not alone in his caution for Emerging Markets

John Paul Smith, chief emerging equity strategist at Deutsche Bank, also told the Reuters Summit that uncertainty over the Chinese economy is clouding the outlook for emerging equities. He recommended a 10-20 percent underweight on the sector over the next six months.

“There’s a significant chance we get a fairly major sell-off,” he said of emerging markets. “China is so untransparent but massively important for asset classes and global markets.”

Joyce Chang, global head of emerging markets research at JPMorgan, said the rate cycle for Brazil, Chile and Israel is not over. “Right now, 16 emerging market central banks have actually raised rates since the beginning of the year. But on average, they’ve raised pretty modestly — only 51 basis points. That’s very modest for 6 percent growth.”  Between now and the end of the year, Chang sees another 60 basis points more of tightening.

Meanwhile, Bernstein noted that the Standard & Poor’s 500 Index is up 1.7 percent this year and that U.S. equities have been the better bet than emerging markets over the last two years.

A government yield curve in general would be upward sloping. But the signal that there’s increased risk of a bear market is not at the beginning of a tightening cycle, it’s when a central bank has tightened too much, he said. The markets almost always take notice.

“How do you know when the central bank has tightened too much? It’s when the yield curve inverts. Historically that has been a fantastic indicator,” Bernstein said.

Indian and Brazil’s yield curve inverted last week

“If you look at inverted yield curves around the world, the most inverted yield curves are Greece, Ireland and Portugal, and then comes India and Brazil. There is your warning sign that no one is talking about,” he said.

Inflation has been creeping up in Brazil and India, where the central bank is expected to raise its key interest rate to 12.25 after the close of market on Wednesday.

Bernstein said emerging market investors are putting a blind eye to the warning signals of a deep decline in emerging markets.

“The common thing you hear, is ‘well, they are overheating,’ which is such a positive spin,” Bernstein said. “The markets are still priced for very rapid unhindered growth, and I just think the probability of that is getting less and less.”