MARKETS

While investors suffered through a lost decade in most US stocks, they found gold in emerging markets.

In six of the eight years from 2002 to 2009, the MSCI Emerging Markets index was the world's best-performing financial asset class, according to Callan Associates, a San Francisco-based investment consulting firm.

We all know why: Emerging markets grew rapidly as exports thrived. With their stronger finances and faster gross domestic product growth, they were a much better investment than the debt-ridden, stagnant developed world, including the good old USA.

The MSCI emerging markets index added 13.2% annually in the ten years from 2001 through 2010, while the Standard & Poor's 500 index (SPX) barely broke even.

But nothing is forever in global markets, and we may be seeing one of those periodic turns of the wheel.

Bangkok, We Have a Problem
Last year, the Wilshire 5000 (DWCF) advanced 17.2%, topping emerging markets’ 16.4% gain. The US market's victory was paced by the stellar performance of small-cap growth stocks, the market's newest hot spot.

And 2011 has so far been a disaster for some of the world's most stellar performers. Emerging market exchange traded funds are “breaking down like crazy,” reports Nicholas Vardy, chief investment officer of London-based Global Guru Capital and writer of the Global Stock Investor newsletter. “They literally are just running out of gas.”

Vardy says that in the last few weeks he's dumped stocks and ETFs from markets such as Indonesia, Turkey, Chile, Colombia, Thailand—five of the best stock markets in the world in 2010! “They are all down 20-22-23%,” he tells me.

They may have further to fall, too—and not just as part of a “healthy” correction. Because inflation is back, particularly in the world's fastest growing economies.
Just look at the numbers:  Brazil, 7.6%; India, 8.4%; China, 5.1%, and Indonesia, more than 6%.

Rising Prices, Rising Currencies
"Headline” inflation includes volatile food and energy prices, which have been soaring because of strong global demand and unusual weather patterns. Copper, cotton, and grains have hit multiyear highs in recent weeks.

These prices do fluctuate more than those that comprise “core” inflation. But growing demand for food, fuel, and commodities from emerging economies—not to mention recovering developed countries—will keep both headline and core inflation higher over the coming months.

And it will hit emerging markets hardest. They're facing rising wages as well as higher materials costs—bad, bad news for companies trying to maintain profitability without pricing themselves out of the market.

The Federal Reserve's loose monetary policy isn't helping, either. “Hot money” is flowing into these markets, raising pressure on prices and driving up the value of many emerging currencies.

The Brazilian real has soared almost 40% from its low, the South African rand has jumped nearly 50%, and currencies from Colombia, Chile, Indonesia, and South Korea have risen by 20% and more.

That will hurt exports, ultimately slowing these countries' economic growth. It's just a bad combination.