(Corrects company name and details of funds under management in 5th paragraph)
LONDON - Emerging markets, the consensus trade for 2011, look set for further heavy inflows of investment dollars, raising questions over how much more new money they can comfortably absorb without igniting an asset bubble.
Most fund managers at a recent Reuters summit picked emerging markets as a top 2011 bet, citing double-digit returns, underpinned by rising incomes and fast economic growth.
Equity portfolio flows to emerging markets are set to reach $186 billion this year, and, while they are seen falling a touch to $143 billion next year, according to the Institute for International Finance (IIF), they will still be more than double the $62 billion annual average seen between 2005 and 2009.
Yet, some are starting to ask if investors are getting carried away. Not only do unbridled portfolio flows risk inflating sector valuations into bubble territory, but the flows may be based on unrealistic expectations of long-term returns.
The bigger bubble risk is the investor expectation of EM, there's such euphoria, said Mark Donovan, chief executive officer of Robeco Investment Management which runs 31 bln euros in U.S. equities. I'm always wary of these herd moves into certain asset classes, generally they are not well-timed.
Donovan does not question the underlying emerging markets growth story. But he and some others believe new investors may be ignoring potential problems, within and outside the sector.
Emerging markets have been in a sweet spot this past year or two as liquidity unleashed by Western central banks has pumped up the market, fuelling double-digit returns.
A Reuters poll forecasts emerging returns will far outstrip U.S. and UK equity gains in 2011.
Excess liquidity, however, is fuelling inflation in developing economies, potentially leading to overheating. Higher U.S. Treasury yields could also become a headwind.
My central scenario is that in 2011 emerging markets will be okay. Given where valuations are you will still get a positive absolute return, said John-Paul Smith, chief emerging markets strategist at Deutsche Bank in London.
But some of the outsize returns forecasts are probably way too high ... I'm concerned that if people become too optimistic we could see a bubble-type situation developing. When the bubble bursts, it has horrible repercussions for the real economy.
EMERGING MARKETS ARE ... STILL EMERGING
One worry, Smith says, is that the inflows risk encouraging emerging policymakers' hubris, removing the pressure for reform.
Some doomsayers note big capital inflow peaks often precede crises. This may be especially true of emerging markets which remains a relatively small, illiquid asset class: the market capitalization of the 37-country MSCI emerging index <.MSCIEF>, is less than a third of the U.S. S&P 500 <.SPX>.
That means a large-scale cash influx can quickly inflate asset prices to unsustainable levels, risking a repeat of the familiar boom-bust emerging market cycles.
RBC estimates that a 1 percent reallocation of global equity and debt holdings will send $500 billion into emerging markets -- more than 10 percent of the MSCI emerging market cap.
At present, emerging valuations are not in bubble territory -- they trade at a discount to developed markets at around 11.5 times forward earnings.
Valuations are still below 2007 peaks and well off levels during the dot-com bubble in the late 1990s when some stocks were trading at 60-80 times forward earnings.
And the volume of securities available for investment is growing. The MSCI EM's market capitalization has grown by around 10 percent a year in the past decade and emerging markets' share of the world index <.MIWD00000PUS> has tripled to 14 percent.
The emerging debt universe too has doubled to around $6 trillion over the past five years, JPMorgan says.
Still, with investors piling in, too much cash could in coming years end up chasing too little market cap.
Global equity fund allocations to emerging markets now stand at 16 percent of assets under management -- in dollar terms that is $1.5 trillion, Barclays Capital said, noting bond allocations are at 7.2 percent. Both are close to pre-crisis highs.
(Positioning) has reached levels at which investors rightly question the sustainability of the EM flows story going into 2011, Barclays analysts said in a note.
SIGNS OF NERVOUSNESS
There are signs of wariness. Many investors say that instead of increasing outright EM longs, they prefer multinationals such as Unilever
Another tactic has been to hedge EM exposure via Australian bonds, which are seen making big gains in case of a hard landing in China -- a scenario feared by many.
Michael Power, global strategist at Investec Asset Management, says 2011 may well shape up to be the year in which investors learn not to be unequivocally bullish on the sector.
People are looking at EM as a cake and saying 'I want a slice,' without looking at the ingredients of that cake. So some countries that are not born equal are being swept along in the trade along with the deserving ones, he said.
When bubbles burst, there is a fallout and the deserving emerging markets will be considered guilty by association.
(Additional reporting by Natsuko Waki; graphics by Scott Barber; Editing by Susan Fenton)