Will the Emerging Markets Investment Craze Lead to Fewer Trade Wars?

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It’s an amazing part of this global economic anemia that investors large and small are finding the best balance of risk and return–and the most gusto– in emerging markets. Just a few years ago these markets were considered the frightening frontier (anyone remember the 1997 crisis?) but increasingly  they are the place where hedge funds, retirees, and everyone in between is turning  for yield, long-term growth and all the things that the developed markets no longer seem to supply.

The performance of emerging markets (EM) so far this year seems to validate the longer term optimism. Thus far in 2010, EM government bonds are leading the investment returns sweepstakes, up 14.8% through September, while the number two spot  goes to emerging market corporate bonds, up 13.7%. Both these categories beat US high-yield bonds as well as investment-grade bonds, which both returned about 11% to 12%. And they trounced the 3% gain in U.S. stocks over the first nine months of 2010.

All this data comes from a new monthly report Merrill Lynch just began publishing on emerging market corporate debt, just one more indication that investors interest in these fast-growing markets is intensifying. The report notes not only the “stellar” performance of emerging market bonds but also that these bonds are enjoying a higher rate of credit-rating upgrades than companies in developed markets. In other words, there’s real progress underlying financial market strength.

So how will the sudden rise of emerging markets affect the global balance (or imbalance, as it were) of capital and currencies? Investment flows out of the dollar could exacerbate the greenback’s decline, but the dollar lately seems more sensitive to Fed actions and news from Greece than it does to capital flows.  Big passive investment flows can also be destabilizing if they overwhelm a small economy’s ability to digest it all. But that risk, typically related to overly loose credit, seems less of a worry in the wake of the great credit blowout from which lenders are still recovering.

On the positive side of the ledger,  the ascendance of emerging markets offers a huge opportunity for the growth challenged asset management industry (i.e., Wall Street.) According to a new report from Goldman Sachs, money managers are facing increasing  fee pressure because their performance has been disappointing, and low cost alternatives to mutual funds, notably ETFs, are growing in popularity. Also Americans are getting older and many will be drawing down their invested savings to fund retirement–yet another reason that assets in mutual funds may decline. As the Goldman report notes, “Supportive macroeconomic and demographic conditions that drove growth of the U.S. market have passed, leaving the [mutual]  fund business saturated with U.S. managers investing in U.S assets.” The advice Goldman Sachs gives to big mutual fund houses: Head to the emerging markets, where people save more–and thus have more to invest– and per capita income and GDP  are rising sharply.

It’s also where U.S. investors are increasingly heading, and that has the further benefit of bringing a bit more yield and growth into U.S.  portfolios. Yes, it could greatly increase risk if the allocation to emerging markets grows too large, but the vast majority of investors are still overly concentrated in U.S. securities.

There’s one other potential benefit to more of America’s investor capital flowing to emerging markets: The more money Americans have a stake in these fast growing markets the less eager American voters will be to see trade barriers erected.

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