THE CASE FOR EMERGING MARKETS EQUITIES.

Summary: Despite the threat of high inflation, emerging markets profit margins beat those of developed countries.

tHE POWER OF CENTRAL BANKS TO INFLUENCE markets is often overlooked by investors who base their buy and sell decisions on charts and the repetitive patterns within them. Even investors who look at valuations can fall foul of changing market conditions because they missed something obvious in hindsight. This year, the behaviour of central banks across the globe will have an enormous impact on markets as last year's inflation problem may not have been solved. As the year unfolds, conditions should favour local GCC equity markets where interest rates are tied to US rates but whose economies benefit from abundant growth along the Silk Route.

In December last year, the European Central Bank set forth with a more expansive support programme for European banks and governments and investors moved back en masse into higher returning assets classes from bonds and cash. The resulting huge gains in emerging markets equities and FX were largely unexpected, in some cases beating the recovery of 2002/03.

MENA markets have had one of the fastest run-ups in prices since the boom days of the early last decade. In US dollar terms, Egypt has gained over 40 per cent since year-end, Dubai's local share market 25 per cent and the Saudi Tadawul index 18 per cent. Emerging markets in general are up 16 per cent year-to-date. Local currencies in emerging markets and local-currency bond markets have followed suit as rising equity markets have taken away the prospect of forex losses by attracting capital flows from abroad.

The improved outlook for growth and financial security has lifted yields on US-dollar denominated government bonds and increasingly shifted the bias from bonds to equity. Dollar bonds throughout MENA, particularly those bonds with higher rated cash flows, now look much less compelling buys than their equity counterparts.

When we look at markets, in particular equity markets in emerging markets, we see a greatly improved outlook for equities. Profit margins are higher than developed countries, earnings prospects are steadily improving and markets are trading at much greater discounts to trend.

Even so, it's not all plain sailing. Unless economies are at the very early stages of development, rising inflation eventually leaves central banks with no choice but to raise interest rates - an action that is damaging to financial market returns if it comes across as too late or as the result of previous mistakes.

As we move towards the second half of 2012, and growth rates in developing countries are confirmed as largely safe from the downturn feared last summer, one factor should be borne in mind by investors in equities. Have central banks cut their interest rates too quickly?

There is a risk that this is true. Intriguingly, yield curves have not steepened. They should have if interest rates were going to fall further. That they haven't implies the recent trend of interest rate cuts in emerging markets may soon end; it might possibly reverse.

At Emirates NBD private banking, we continue to believe that there is a compelling long-term case for investing in emerging markets equities; but we also urge our investor community to consider closely the role that central banks play in markets and to keep a vigilant watch for signs that the battle against inflation wasn't won last year. We are confident that it was, but if not, then we could see central banks raising rates again in late summer.

If that does come through and assuming, as we do, that GDP growth rates in developing countries will remain impressive, then local equity markets will continue to be appealing since GCC countries tied to US interest rates do not have the risk of higher interest rates later in the year.

"AS THE YEAR UNFOLDS, CONDITIONS SHOULD FAVOUR LOCAL GCC EQUITY MARKETS WHERE INTEREST RATES ARE TIED TO US RATES BUT WHOSE ECONOMIES BENEFIT FROM ABUNDANT GROWTH ALONG THE SILK ROUTE."

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