The Biggest Threat to Emerging Market Stocks

In global economics, there are several emerging truisms. Growth is likely to be somewhat muted in the West as efforts to reverse massive budget deficits will create a drag as governments tax more than they spend. A second truism: emerging market economies have come a very long way in a very short time, and they’re unlikely to revert to their old habits that stifled growth. [See: “Forget About BRIC — Buy These Emerging Economies Instead”]

The third truism: these upstart economies are likely to stumble on their way to a higher plane. The biggest concern: inflation. It’s just appearing now, and could well get much worse in 2011. And if that happens, many of the world’s hottest stock markets — many of which have doubled or even tripled in the past two years — could be hit by profit-taking.

In recent days China has expressed increasing concern that inflation is starting to percolate. The government is seeking to rein in bank lending and has also started to impose price controls on key foodstuffs. But China is lucky. Its economy has so many hidden strengths, its policy planners can implement measures without pushback from independent central banks, and it is not especially reliant on imports.

#-ad_banner-#Yet many other developing economies have no such luck. They have much less control over their economy and are much more exposed to the vagaries of economic activity outside their borders. Vietnam is a prime example. Its economy is likely to grow +6% to +7% this year, but inflation is likely to exceed 10%. That’s why Vietnamese stocks have not participated in the global rally. The Vietnam Market Vectors ETF (NYSE: VNM) is roughly flat in the past year.

Rising inflation hurts equity investments in myriad ways, including:

1. Consumer activity slows as recent entrants into the middle class find that basic staples eat up more of their paycheck. Just this week, Brazil raised the reserve requirement for banks, which means less money will be in circulation.

2. Governments look for ways to rein in prices by raising interest rates, making higher-yielding emerging market debt more appealing than emerging market equities.

3. Higher prices lead to a weakening local currency, so investments translated into dollars lose value.

Rising inflation stems from a pair of factors. Economic activity that exceeds the infrastructure that is in place, creating bottlenecks. Think of urban traffic jams, slower factory delivery times and an increasing shortage of reasonably-priced skilled labor. The second factor is input prices. Rising costs for imported oil, fertilizer and raw materials all lead to an uptick in prices throughout the supply chain. In many emerging economies, both of these factors are coming into play. Cities such as Bangalore, Jakarta and Phnom Penh have all been in the news recently as they are starting to creak under the weight of too much commerce and too little infrastructure. Analysts at Morgan Stanley have already charted out the divergent inflation pictures, as seen below.

Yet it’s the commodity action that stands to crash the emerging markets‘ stock market party. Crude oil for example, now approaches nearly $90 a barrel, roughly +30% higher than six months ago. [Why 2011 Could be the Year of the Oil Comeback]

If oil keeps rising — past $100 a barrel — it’s hard to see how a lot of these economies, many of which are net energy importers, can escape the inflation bugaboo.

For oil and other commodities such as steel, fertilizer, copper, aluminum, etc. not to see a spike in 2011, the global economy would need to putter along at a lukewarm pace. Right now, we’ve got robust activity in emerging market economies and tepid economic activity in the United States, Japan and Europe. What happens if these lagging economies start to rebound? That’s the nightmare scenario for emerging economies, as demand for many basic materials could quickly outstrip supply, as we saw in 2008.

Action to Take –> Emerging markets still look like a great long-term bet, as rising middle classes put their economies on a potentially far higher plane. But a lot more could go wrong than right in 2011. It’s been a goldilocks scenario for several years now, with economic growth hot and inflation cold. Signs are now emerging that the hot economies are leading to hot action in prices as well.

If you’re invested in any emerging market economies, you may want to book profits if monthly inflation figures start to rise. And for those not yet in emerging markets, the short side of the trade looks better these days after stunning +100% and +200% upward moves.