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By Jason Stipp | 11-11-2010 03:48 PM

Emerging Markets Investors: Time to Check Expectations

Valuations are beginning to disconnect from the pace of fundamental growth in some emerging markets, but targeted values can still be found, says Matthews Asia Funds' Andrew Foster.

Jason Stipp: I am Jason Stipp for Morningstar. It's International Investing Week on Morningstar.com, and today we're focused on emerging markets, an enduringly popular area with investors over the last year or so based on Morningstar's fund flow data.

Calling in today from Matthews Asia Funds is Andrew Foster. He is a portfolio manager there. This is one of our favorite asset managers in the region. He is going to give us a little sense of the lay of the land. Andrew, thanks for calling in today.

Andrew Foster: My pleasure, Jason.

Stipp: The first question for you, based on the Morningstar's fund flows, emerging markets as well as some more conservative asset classes have been particularly popular with investors, and certainly the emerging markets have had topnotch performance over several trailing time periods. In your perception, is the emerging-markets area becoming overheated based on all the attention that it's had recently from investors and its recent performance?

Foster: I am so glad you brought that question forward and precipitated the issue. I think it is time for investors to at least cool down or possibly even reset their expectations for the performance of this category in the coming years, at least when I look at these emerging markets from an Asian context. I am not particularly an expert over Latin America or Eastern Europe.

The reasons I say this: I've just returned from several visits in the region itself doing the sort of research we do in the field there, and I think growth is undoubtedly strong in many of the markets at an economic level, and I think we're quite encouraged as to what we see unfolding over the next few years.

That said, we have seen valuations be pushed steadily upwards for quite some time now. In my opinion, a lot of the performance we've seen in recent months has more to do with the influx of liquidity in the markets in Asia, partly driven by some of the quantitative easing going on in developed markets around the world and other factors, especially many of the markets in Asia themselves are quite replete with savings and liquidity.

And consequently, we've seen valuations push steadily upward, and they are beginning to disconnect a bit I think from the pace of fundamental growth in these markets. That always worries me when we have valuations separating from the underlying fundamentals and macroeconomic conditions.

I would highlight this especially just on China, because I think it's very clear to me, again, at least that the economy there is going to be on a decelerating trend over the next few years. We are not talking about growth falling off a cliff, but the authorities in that country are working very aggressively to restructure and reposition the economy, and I imagine that will mean a deceleration in headline growth rates from the sort of 9% to 10% rates of growth that people have grown accustomed to, to something probably between 6% and 8% in the next few years.

I am just not certain that investors are really aware of this issue or are focusing on it, and I think it's very important that they do so.

The last thing I would say on this: Perhaps the most crowded trade of all at the moment is the short dollar trade. There is a huge amount of capital pushing into Asian currencies and Asian currency-denominated securities such as stocks and bonds. There is somewhat of a flight from perceived weakness in the dollar, and I can understand certainly why people wish to make this trade, but it's become very crowded. I think it maybe overestimating some of the underlying strength in the Asian currencies at least in the short run.

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