Emerging markets. Will the party run out of punch?

The emerging markets have been enjoying a powerful mix of accelerating world economic growth, high oil and commodity prices, a weak dollar, and extremely low US interest rates. Monetary policies in the industrialized countries remain unusually accommodative despite real global GDP growth in 2004 that we expect to be the second highest of the past ten years. Emerging markets are facing two critical issues, however--rich valuations and the Fed's "exit strategy" from 1% interest rates. Since skepticism lingers about the sustainability of the world recovery, the Fed seems to be the biggest concern, as investors fear that the party can only last until Alan Greenspan takes away the punch bowl. We beg to differ.

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It's all about growth. The investment case for emerging markets hinges on economic growth and on institutional and political convergence with developed markets. We see much evidence of convergence: China's and India's increased involvement in world trade for goods and services, successful political transitions in Brazil and Turkey, Russia's fiscal consolidation, and the emerging world's growing reliance on flexible exchange rates and decreasing dependence on capital inflows.

Growth is the necessary condition for these transformations to be sustainable, and we expect global GDP to surprise on the upside. Despite the efforts of the Chinese authorities to slow the economy, we estimate that developing and transition economies will grow faster than the advanced countries in 2004 by 2.5 and 1.5 percentage points, respectively. Economic performance across regions should also exhibit a lower variance than in 2003, thanks in particular to a recovery in Latin America.

Granted, emerging markets face risks. Valuations are already above historical norms in certain emerging credit and equity markets. Asian growth could ultimately boost prices of intermediate goods and global inflation above the low expectations priced into the bond markets. Even in a scenario of still-moderate but rising inflation, US bond yields will probably go up over the course of this year. When the liquidity tide turns, sovereign emerging market debt issuers will have a harder time persuading investors to accept historically low yields. Moreover, unforeseen sources of financial instability may arise, and political improvements could be reversed.

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However, emerging markets are closer to fulfilling their secular growth promise than at any time since the early 1990s, largely as a result of Asia's economic ascendancy. We expect them to overcome the transition in G-3 monetary policies likely in late 2004 and, more significantly, in 2005. Given our views on global growth and its drivers, we favor markets that are primarily driven by growth, oil, and commodities as opposed to liquidity and/or political factors.

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This is an edited excerpt from "Emerging Markets: How Sweet is the 'Sweet Spot'?" by Riccardo Barbieri Hermitte, dated February 6, 2004, published in EMEA This Week. For a copy of the full article, including important information and disclosures regarding Morgan Stanley, please see www.morganstanley.com/ourviews or contact 1-800-962-1343. This article does not provide individually tailored investment advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. It was based on public information, and Morgan Stanley makes no representation that it is accurate or complete. Estimates of future performance are based on assumptions that may not be realized. Investments and services are offered through Morgan Stanley & Co. Incorporated, member SIPC. Morgan Stanley and One Client At A Time are service marks of Morgan Stanley. [c] 2004 Morgan Stanley.

Riccardo Barbieri Hermitte, Emerging Markets Economist