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Will QE2 Create a Bubble in Emerging Markets?

Well, it turns out the Federal Reserve's $600 billion quantitative easing policy known as QE2 isn't just controversial on our own turf. Economic leaders in emerging markets are none too pleased with Ben Bernanke's big gamble, either. The fear is that the Fed's QE2 policy will set off a bubble in emerging markets. The U.S. dollar has already taken a big hit because of QE2, igniting currency-war saber rattling that should be a featured event at the upcoming G20 summit later this week. And the longer-term concern is that if, as the Fed intends, businesses and investors do grow sick enough of the paltry yields available in U.S. fixed income investments and look for alternatives, the strong-growth economies in emerging markets will see big inflows.

Over the weekend, Treasury Secretary Tim Geithner suggested the emerging markets doth protest too much. In comments to reporters while in Tokyo ahead of the G20 confab in South Korea, Geithner said strong capital inflows into emerging markets are "a positive reflection of confidence in the likely trajectory of growth rates in those countries over time," adding that "you can have too much of a good thing, but it is fundamentally an encouraging thing."

Emerging Markets: A Super Goldilocks?

What Geithner and just about everyone else recognizes is that emerging market economies have the best growth prospects going forward. The International Monetary Fund's latest forecast pegs emerging market growth in 2011 at 7 percent, compared to 2.5 percent for "advanced" economies. Even though the MSCI emerging markets index is up more than 15 percent year-to-date following its 75 percent rise in 2009, there's still the expectation among many investing pros that emerging markets can keep rising.

Last week, Citigroup's chief emerging markets strategist described the investing prospects for emerging markets as a "Super Goldilocks environment" that could see another 30 percent rise in 2011.

And an interesting trio of investing eminences grises are also singing emerging markets praises. Mark Mobius, the long-time head of international investing at Franklin Templeton, told Bloomberg that QE2 policy will be good for global markets, with emerging markets being the "bright spot." Barton Biggs, the former head of Morgan Stanley Asset Management, and Jeremy Grantham, a widely read market strategist, are also on record as saying that emerging markets are the global sweet spot at the moment.

It's Still a Bubble, Though

But make no mistake, both Biggs and Grantham are quite clear that this is indeed a bubble; the opportunity is only that we are seemingly in the early stages of the run-up. Biggs, the current head of hedge fund Traxis Partners, recently told Bloomberg that "we're only halfway along the way to a gigantic eventual bubble in the emerging markets." And in Grantham's recent 3rd quarter letter, he reiterated that his "emerging markets bubble thesis" is still in splendid shape. "Emerging markets are admittedly fully priced, but they still sell at a decent discount to the 75 percent of the S&P 500 that are not quality stocks," Grantham wrote. "With their high commodity exposure, their strong finances, and their strong GDP growth especially, I believe that they will sell at a premium to the S&P, perhaps a big one."

A Question of Timing

The chart below from fund-flow research firm EPFR Global shows that individual investors are indeed well aware of the emerging market story, making it the market of choice for new stock fund investments:

EPFR reports that the $74.5 billion inflow into emerging markets mutual funds so far this year could beat out last year's full-year tally of $83.3 billion.

In the short-term, it sure seems that emerging markets are poised to deliver. But your retirement and other investing is a long-term affair. As we saw with the collapse of the internet bubble a decade ago, making money on the upside isn't worth much if you end up staying way too long and catching the painful ride down. And if there's one thing individual investors are good at, it's bad timing. Just keep that in mind in the coming months if you find yourself beginning to salivate over what may well be outsized gains in emerging markets.

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