No easy answers in emerging markets

You probably don't need to worry about the outcome of the UK general election if you're a long-term investor. As our feature shows, elections don't affect the stock market anything like as much as events elsewhere in the world.

But let's say you are getting a bit nervous about the outcome, or consider it prudent to introduce a little more diversity in your portfolio. Where should you invest? The US market looks increasingly overvalued; there's a lovely chart doing the rounds at the moment showing how the All World index (over half of which is US companies) has diverged from earnings estimates, suggesting that valuations are not supported by rising profits.

Europe used to be cheap. But since Mario Draghi, the European Central Bank president, cranked up the printing press and mandated national central banks to start buying government debt, European investors have thrown caution to the wind. The most obvious manifestation of that has been falling and in some cases negative bond yields; even bailed-out Spain can borrow for 10 years at 1.27 per cent.

But stock markets have partied too. This may well continue, as FT Money columnist Ken Fisher pointed out last week. Germany's Dax is up 24 per cent this year (in euro terms), about three times as much as the FTSE 100. Meanwhile in Japan, the Nikkei broke through the 20,000 points barrier this week, so only another 20,000 points to go until it retakes its 1989 high.

What of emerging markets? It's no longer possible - if it ever was - to talk about emerging markets as a single bloc. More than ever, they fall into groups: oil producers and oil consumers; those dependent on exports and those increasing consumption; those that have embraced structural reform and those that are in denial: those with large debts and those with sounder finances. Even the index providers don't agree when it comes to emerging markets: FTSE says South Korea is a developed market, MSCI says it isn't.

Valuations vary quite widely too. India, the star performer of last year, is still going great guns - it's a beneficiary of lower oil prices and has a reformist government with a strong mandate and lots of goodwill. But according to Bloomberg data it's no bargain, with its stock market trading at a higher valuation than the US. Most India equity funds posted big gains in 2014.

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Brazil too is looking fairly cheap, but the news flow is awful: street protests, water rationing, corruption scandals and outbreaks of dengue fever. And then there's China, fascinating as ever. Its economy is slowing; first-quarter output was up just 1.3 per cent, according to official figures, and analysts at Lombard Street Research think it actually fell 0.2 per cent.

But you'd never know that from looking at its domestic stock markets. A-shares are in the midst of a spectacular bubble, having already doubled over the past year. A bit of number-crunching by my colleague James Mackintosh, the FT investment editor, shows that the median price/earnings ratio in Shanghai is 30, and in Shenzhen it's 39 - more than double the S&P 500's 18x.

Money has flowed out of the real estate market and "shadow banking" system and poured into shares; at one point last year, brokers were opening 97,000 new trading accounts every day. Deutsche Bank points out that median valuations for Chinese technology stocks are now twice what US tech valuations were at the peak of the dotcom boom.

There are some exchange traded funds that track the A-share market - BlackRock launched another one just this week - but most foreign investors don't buy domestic Chinese equities. They are not included in the MSCI Emerging Markets index, because MSCI thinks China's capital markets are not yet open enough. Look at the top 10 holdings in many actively-managed China funds and you'll see companies like Tencent, China Mobile and CITIC Pacific. These are big parastatal companies whose shares trade in Hong Kong or New York. The indices that track their performance are up by more prosaic amounts and trade at lower valuations.

< > Finally, the entire investment case for emerging markets is complicated by the recent strength of the dollar, which has risen against many other currencies because investors are expecting US interest rates to rise at some point this year.

A rising greenback is generally considered bad for emerging markets, because it encourages capital flows back to the US and makes dollar-denominated debt (of which they have a lot) much more expensive. Countries with a lot of dollar debt, such as Turkey, have had a torrid time.

The rise in the dollar might not continue, given that recent US economic data has been on the weaker side. But just this week, the IMF warned of the potential for a "super taper tantrum" once the Federal Reserve starts to raise interest rates - and given that the original "taper tantrum" in 2013 caused a big sell-off in emerging stock markets, it's a threat to be taken seriously.

Jonathan Eley is editor of FTMoney. [email protected]. Twitter: @jonathaneley

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