Merrill: It’s back to the future in emerging markets

Merrill: It’s back to the future in emerging markets

It’s 1998 in reverse, according to a new research report from Merrill Lynch, which neatly explains how any easing of rates by the Fed to soothe pain in the US subprime mortgage sector could fuel the biggest bull run ever seen in emerging markets.

In other words, US subprime lenders are going to help inflate an emerging-markets asset bubble and according to Merrill, the ride is going to be sweet.

The 4.5 year bull run in emerging markets remains young by historical standards, the report reasons. And yes, such “secular”bull markets as the ones we saw for US small caps, Japanese equities and tech stocks tend to culminate in a bubble phase characterised by “greed, leverage and egregious valuations”. We know what happens after that.

But before any sticky endings, there are alluring returns to be made, says Merrill. If the Fed eases rates due to US housing woes in 2007-08, the investment bubble will begin, and emerging market returns in the coming year “may pale in comparison with recent years”.
The MSCI emerging markets index could soar to 2010 by 2010 — a 20 percent annualised return from its current level of 964, the report predicts.

The underlying fundamentals in emerging markets are “superb”, says Merrill: “We continue to believe the asset class is undercapitalised, under-leveraged, under-owned and under-valued.”

So, in a mirror image of 1998, emerging markets are the asset to buy in increasingly frequent bouts of market volatility. Credit problems are now in the US rather than in emerging markets. Liquidity to ease the US credit problem will be redirected toward emerging markets , just as liquidity to ease the Asia/LTCM problems last decade was redirected toward the tech sector.

But we’re not yet in that golden bubble phase, says the report. Leadership is still broad within the equity markets, there are no signs that equities are ignoring rising yields/inflation in the bond markets, and complacency and certainty is still scarce - so long as people keep asking “can emerging markets survive a US slowdown?” Merrill is bullish.