ANALYSIS-Dousing the fire of red-hot emerging markets

                                
 By Jeremy Gaunt, European Investment Correspondent
                                
 LONDON, July 20 (Reuters) - There is no getting away from
the fact that much of the bullishness that has gripped financial
markets for most of 2009 comes from emerging markets.
                                
 The question is whether it is sustainable. Is the
outperformance over developed markets excessive?
                                
 Equities in the sector <.MSCIEF> are up more than 42 percent
so far this year, based on MSCI's readings. It is a stunning
performance even if a lot of it does reflect a rise from a low
base.
                                
 By contrast, MSCI's index for developed markets stocks --
which has a similar base effect --  has gained just 7.6 percent.
                                
 While bourses in China <.SSEC> and India <.BSESN> are up 79
percent and 57 percent, respectively, Europe <.FTEU3> has eked
out gains of around 6 percent and America's blue-chip Dow Jones
index <.DJI> is still dipping in and out of the black.
                                
 Emerging market bond yields, meanwhile, have been tightening
against U.S. Treasury yields, narrowing by nearly 3 full
percentage points since March <11EMJ>.
 Some warnings are being given. Michael Hartnett, chief
global equity strategist at Bank of America Merrill Lynch, wrote
last week that there was a short-term risk to emerging equities.
                                
 He based this on his firm's monthly poll of fund managers,
which showed a net 54 percent of respondents were overweight in
emerging market equities, the second highest on record, and only
10 percent actually underweight.
                                
 "Such extreme positioning has typically been followed by a
period of relative underperformance," Hartnett wrote.
                                
 He is not alone in believing the sector has perhaps got
ahead of itself.
                                
 "The last time stocks in developing countries got this
expensive was in October 2007," said Andrew Milligan, head of
global strategy at Standard Life Investments.
                                
 
                                
 SOME MORE EQUAL
                                
 There are, however, two major factors mitigating against a
major retrenchment in emerging markets even given the run-up in
prices.
                                
 One is that the sector is no longer the homogeneous
investment target it once was.
                                
 Standard Life Investment, for example, is negative on the 
sector as a whole, recommending a very light exposure to the
asset class because of potential capital outflows due to the
credit crisis.
                                
 But it notes that some countries are protected from credit
concerns because of their current-account surpluses. Milligan
says the firm is quite keen on Brazil, for example, but dead set
against eastern Europe.
                                
 The Bank of America Merrill Lynch poll also shows a wide
diversity in fund managers' exposure, with many shying away from
Malaysia, Poland and Chile, but embracing Indonesia, China and
Russia.
                                
 This means money may be just as likely to shift within
emerging markets as to pull out altogether.
                                
 This was seen clearly earlier in the year and back into 2008
when the fall in commodity prices prompted emerging market
investors to favour consuming nations over producers.
                                
 
                                
 WHITHER THE WORLD GOEST
                                
 The second factor likely to keep emerging markets on the
boil is global economic recovery. In this light, the performance
of emerging markets since hitting an all-time high on November 1
2007 vis-a-vis developing markets is instructive.
                                
 MSCI's emerging market index lost 67 percent from peak to
trough and has since recouped 40 percent of the points it lost.
The developed market index lost 59 percent and has regained only
30 percent of that loss.
                                
 In other words, emerging makets have been playing their
traditional beta role of underperforming on the way down and
outperforming on their way up.
                                
 So it follows -- if recent history is a guide -- that for
emerging markets to retrench, developed markets would have to do
so too.
                                
 But it is now widely assumed that there is a more than even
chance the developed world, led by the U.S. economy, should see
a slow upturn in the coming half year or so.
                                
 This would be a fillip to emerging markets.
                                
 "Historically, risky assets have performed better in the
months following upward revisions to GDP and corporate earnings
forecasts," Goldman Sachs said in a note on Monday. "The latest
data suggest that on both the growth and earnings fronts,
forecast revisions have turned positive."
                                
 In effect, if the world is going to grow, then emerging
markets would appear to remain the place to be. But the warnings
against ebullience have nonetheless been sounded.
                                
 
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 (Editing by Stephen Nisbet)