Rate Hikes Mean Emerging Markets Will Continue to Be Volatile

Jan.10.11 | About: iShares MSCI (EEM)

Even as investors become more accepting of investing in emerging markets, fears are growing that interest rate hikes in emerging countries will lead stocks there to underperform.

In response to surging food and commodity prices, India, Brazil, Indonesia and China have been hiking interest rates. The Food & Agriculture Organization’s index of 55 food commodities has risen 24% since July, and because food prices can make up 20-50% of emerging economies' CPI baskets, the issue is a burning concern for these countries. Commodities in general, as measured by the Jeffries CRB Commodities index, are up 28% since July. These inflationary pressures are adding to wage and input costs and crimping already-tight profit margins.

While placing your bets across a variety of emerging markets does have diversification benefits, emerging economies are very interlinked economically, and international "hot money" tends to move in and out of emerging markets as a whole. This can lead to separate emerging markets moving downward in unison when global stock prices decline.

Many individual investors, particularly those new to the asset class, may be shocked by the volatility of emerging markets. The MSCI Emerging Markets index (NYSEARCA:EEM) fell 58% between 1994-98 and 63% between 2007-09.

While valuations for emerging markets do not seem excessive at the moment, there is a concern that the sector may be overbought. According to a recent Russell Investments survey, 71% of investment managers were bullish on emerging markets, the second-most favored asset class in the survey.

Another clear sign of how popular emerging market investing / speculating has become is the very large number of emerging market ETFs now available; the fact that so many such ETFs exist for this asset class should give investors pause for thought..

While these economies may well have a bright future over the longer term, the road for investors in emerging market stocks will be rocky and not for the faint of heart.

Disclosure: I am long DEM.