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How To Stop Worrying...
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Emerging market shares are already expensive relative to developed market ones, but economic growth in places like China and India will continue to pull away, and investors will pay an increasing premium for that, especially if the ageing economic giants of the 20th century slip from their long term growth paths.
And in a process we have seen before with internet stocks and houses, big returns will attract big money, driving further rises and making it all seem very sensible, at least for a while.
The definition of "a while" is of course, as with all bubbles, the key question.
Amazingly, the case for emerging markets being both a bubble and a good investment is being made by legendary value investor Jeremy Grantham.
"This bubble, like all bubbles, will not be justified by long-term value but at least will be one of the least flaky bubble cases ever," Grantham, chairman of fund manager GMO, wrote in a note to clients.
"Perhaps once in a career any self respecting strategist, even a one trick "mean reversion" one like GMO, should have a go at predicting a major divergence, a true bubble. And this is ours."
He points out that US gross domestic product has in recent years been growing at below its long term 3.5 per cent rate in real terms, despite a very supportive global environment and huge amounts of cheap financing.
At the same time, growth in emerging markets is higher, and is supported by boom prices for commodities and by a seemingly unstoppable movement of people into cities, driving both consumption and higher productivity.
Grantham's thesis, essentially, is that these diverging trends will continue, that everyone will realise it and that they will pile into emerging markets, thus inflating the bubble.
How big a bubble? The Japanese bubble peaked at a price to earnings ratios two to three times that of the rest of the world's stocks, while the NASDAQ one reached similar figures, according to GMO. Grantham argues that emerging markets could achieve a premium of 50 percent, which would be "far less than normal," but still a heck of a lot higher than current levels.
Decoupled, Weakly Coupled Or Tied At The Neck
Emerging market shares are now more expensive on a reported earnings basis than developed market stocks, a historically unusual situation.
Emerging shares are now selling at 15.9 times their reported earnings, as against just 14 times for developed markets. The median over the past 13 years is 15.6 for emerging and 22 times for developed, according to data from Societe Generale.
So, investors are paying more for a dollar in emerging markets earnings than they will for a developed earnings dollar, and a major relative change in valuation has already happened. Can this continue, even if growth in the United States and Europe is weak?
Andrew Lapthorne, global quantitative strategist at Societe Generale Corporate & Investment Banking in London, is not so sure.
"Are emerging markets a commodity play? Yes. Do they have better growth prospects? Yes. Can they withstand a slowdown in the United States and Europe? Probably not," he said.
Grantham, for his part, believes that the bubble will be influenced, and perhaps delayed, by problems elsewhere.
"Such interruptions may be quite violent but, despite them, at the next low point for the US market the emerging markets are quite likely to do no worse and in the recovery they will go to a very large premium," he writes, adding that in the slower case the 50 per cent premium would be reached within five years. If the US somehow skates through, then it would be all the faster.
There are other arguments in support of emerging markets that are actually strengthened by the woes elsewhere. Leverage is lower in emerging markets than developed, both at the corporate and household level. If we are going through a sustained period of lowering the amount of borrowing that is acceptable, Asia's banks and consumers are less exposed.
And the increasingly affluence of consumers in emerging markets offers another potential stabiliser. Credit Suisse points out that about half of global emerging market exports are to other emerging markets, as against 18 pe rcent to the US.
There is also a school of thought that says, like it or not, global financial capitalism is inherently prone to bubbles, so we should all just relax and enjoy it.
Indeed, since the Federal Reserve and other authorities have demonstrated that they will step in to cushion the effects of a popping bubble but not act to stop one inflating, you can be forgiven if you think it might be fun to hitch a ride.
It may be moral hazard, but what, after all, is a speculator to do? Just make sure you get out good and early.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund)
James Saft is a Reuters columnist. The opinions expressed are his own