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Herb Stein, economic advisor to Richard Nixon, said "That which cannot continue won't". Looking at some of the imbalances in the financial markets today, Stein's quote can be applied quite handily. The mad rush to seek opportunity abroad has resulted in the overvaluation of some emerging market equities, bonds and currencies.

In 2010, investors poured monumental cash flows into the stock and bond markets of the emerging markets. The capital inflows exacerbated the inflation situation in these countries as this hot money from the developed economies sought out risk and higher returns.


Cross Border Investment Management

It is estimated that last year, the emerging markets received almost $900 billion in net capital inflows. As this capital poured in, it ran the risk of overheating the emerging market economies as it did in the late 1990s - creating the Asian contagion. To offset these dangers, many of these countries have tried various policy measures to discourage this activity. Some have resorted to devaluing their currencies (most recently Vietnam and Chile) or to impose taxes on capital (Brazil).

The difficulty is that some of these policy measures can make inflation worse. The inflation pressures in the emerging markets has also been made worse by some of the strongest rate of increase in food prices in decades. Throw nearly $90/barrel oil into the mix and we have a recipe for an unhappy ride.

January 2011 Investment Strategy Notes

In some discussions, blame has been heaped upon the US Federal Reserve and its easy money policies for helping to fuel the inflationary uptick. While this is certainly a defensible position, quirky weather around the globe has also played a part. In countries such as India where millions of people spend over half of their income on food, rising food prices due to bad harvests brought on by weather can cause havoc for its economy. To its credit, the Reserve Bank of India has tightened monetary policy by raising interest rates seven times since March 2010 to offset the rise in inflation.

As the accompanying chart shows, India's stock market was able to shake off these fears and the fact that its central bank was raising interest rates for much of last year - until US treasury yields (interest rates) bottomed. The bottoming in US interest rates coincided with the beginning of the recent 20% decline in the Indian stock market in the last three months.

Taking into account Stein's quote above, the inflows have started to moderate as capital has been leaving India and other emerging markets for stable jurisdictions such as North America. Clearly, the Indian market has signaled that rising inflation will take a bite out of India's economy. For 2011, economic growth will still be impressive but perhaps the market has returned to a more balanced outlook. Certainly, the rapid decline as has been witnessed could be providing some interesting opportunities for bargain hunters.

Source: Hot Inflation Cools Emerging Markets