From the Editor
	Crash Course Dwight Cass 08/01/06
	Journalists who predict market downturns can take some comfort from the fact that they will, eventually, be proven correct. However, those lone wolves who start too soon, like those who began heralding the dot-com crash in 1996, are not remembered fondly by their readers, at least those who heeded their warnings and stayed on the market sidelines. The outpouring over the performance of the markets, and especially emerging markets, from the financial commentariat over the last two months has had a distinctly March 2000 feel about it. But the issues facing investors right now are significantly more complex than those that inflated and popped the Internet bubble. The sudden drop in appetite for risky assets precipitated by the higher-than-expected April inflation figures, combined with concerns over the alleged inflation dovishness of Fed Chairman Ben Bernanke—and a series of otherwise hawkish remarks by a number of his Fed colleagues—tripped emerging and developed markets alike in May and June. As investors began to recognize that interest rates would continue to rise—not only in the eurozone and Japan, but here also—they suddenly realized it might make sense to shift from increasingly expensive risky assets to those lower-risk, cash-like instruments whose returns were inching upward. It didn’t help that, within a two-week period, the European Central Bank issued a report likening the risks posed by hedge funds to that of a bird flu pandemic, the president of the New York Fed said banks were not exercising enough caution in their lending to hedge funds, and the World Bank said a number of developing economies were at risk from investors’ sudden flight to quality. Inflation, rate hikes and this litany of woe—no wonder markets around the world plunged. The stock market’s skittishness and stumbles captured most of the headlines. However, valuations in the domestic equity markets remain reasonable and corporate profits still relatively strong. It is the formerly high-flying emerging and commodity markets that are the real worries. Indeed, it looked for much of May and June as if the four-year emerging markets bonanza had run its course. But there is an important difference between a return to fundamentals and an outright crash. With the private investor community exposed to emerging economies through hedge funds, private equity and direct investments (not to mention their increasingly important role as funders of U.S. profligacy) the health of these markets is crucial to our own well-being. Fortunately, not all the news is dire. Much of the capital that has flowed in recent years to emerging markets has been direct, rather than portfolio, investment. This is stickier than the sort of hot-money flows that washed in and out of these countries in the Tequila, Asian, Brazilian and Russian crises of the 1990s. A fair amount of that direct investment is coming from other emerging markets, such as China, which are running account surpluses. These countries are eager to invest that capital in ways that accelerate their own economic development. They are making long-term investments that support asset prices and growth in other emerging economies, all of which indirectly benefits portfolio investors. There is also a geopolitical benefit—if, for example, China and India invest in one another’s markets, it raises the cost of conflict between two traditional enemies. Understanding the type of markets that can be profoundly shaken by something as off-the-radar as a fiscal crisis in Iceland (which caused a severe hedge fund shake-out in March, with widespread repercussions for other emerging markets) is no easy matter. The fundamental premise of doomsayers, that rising interest rates in the U.S., Europe and Japan will mop up a lot of the excess liquidity that has driven technical gains in markets around the world, is correct; the extent to which this will reverse those gains, rather than simply moderating them, is anyone’s guess. While simply investing in a broad portfolio of emerging-markets assets is probably no longer the easy ticket to double-digit returns that it was two or three years ago, there will still be enormous opportunities in individual markets—for those smart enough to find them.