Emerging markets' potential involves high risk

Serious Money:  Anyone looking for the best returns would have been well advised to invest in Peru during the first half of 2006.

In fact, the Peruvian stock market has been going up in a straight line, more or less, for the past four years. It is up by nearly a factor of eight (yes, eight) since 2002 and the recent sell-off, which hurt emerging markets more than most other asset classes, already looks no more than a blip for a stock exchange that has continued to power to new highs. The stock that we should have invested in is called Volcan: few people will be surprised to learn that this company operates mines and refineries and primarily produces zinc, silver and lead.

This is a company that appears to have risen sixfold this year alone. One might be tempted to suggest that a large part of the good news story, whatever it is, must now be in the price. Nevertheless, these sorts of numbers remind us that some of the world's most attractive - and riskiest - investments still lie in far-flung corners of the globe.

Compared to Peru's near 80 per cent first-half gain, a rise of 59 per cent in China's Shenzen Composite index looks rather sedate. But like Peru, the Chinese market has gone on to new highs following the global correction in May.

The Chinese story is, of course, more familiar to us than is the Peruvian narrative. An economy that has been booming for the past quarter of a century would be expected to have produced one or two stock market successes.

But if China has been a one-way bet in terms of its economy, investing in that success story has been far from straightforward. Indeed, at the start of this year, the Shenzen Composite had been falling steadily since 2001 and was actually lower than in early 1992, not long after the index was invented. So, 2006 has been the first good year for investors in Chinese equities for some time.

There are a few reasons for this. Earlier falls had perhaps been overdone, the economy has shown no signs, so far, of the feared hard landing and the authorities have been trying to remove some of the more obvious excesses and corporate governance worries associated with Chinese equities.

Wider share ownership is being encouraged. Nevertheless, only early steps have been taken to overcome the problems with Chinese stocks and investors with a weak constitution should not consider them. As with Peru, great rewards only come to those prepared to take large risks. Anecdotal evidence that the government's recent attempt to curb bank lending has stopped the property market dead in its tracks should serve as a health warning about what might happen next.

The worst market during the first half of the year was Dubai (-58 per cent), followed by Abu Dhabi (-31 per cent). Of course, these relatively small markets had previously run up very far, as the rise in oil prices sucked huge amounts of petrodollars into the Gulf states, fuelling an economic boom and, arguably, not a little speculation.

The reasonably well-documented falls in the region's stock markets show all the classic signs of bubbles bursting. If stock and property markets are thought to be correlated - or perhaps one sometimes forecasts the other - investors in Dubai's real estate sector might ponder the fact that the equity market has recently continued to set new lows.

Closer to home, the two markets that we should have placed some bets in were Russia and Croatia. Russia has been hot for obvious reasons: oil prices have clearly been the main driver, along with the prices of many other commodities. If anybody knows anything about the Croatian stock market could they please let me know?

Observers of the European M&A scene will not be surprised to find tiny Luxembourg topping the performance league tables. It is a market with few stocks and one of them, the steel company Arcelor, posted a near 80 per cent gain as it engaged in its long takeover dance with Mittal Steel. A combination of deal activity and involvement in metal bashing has been a very heady combination.

Of the larger European markets, Spain has been one of the best performers with a 7 per cent rise. Germany and France have not been far behind, displaying about 5 per cent gains.

When we add in dividends to these returns, we can see that equities have had, so far at least, another good year, beating bonds again. And that's with a fairly hefty correction in May.

What lessons can we draw from all of this? My own hunch is that these patterns will, broadly speaking, continue: emerging markets will stay volatile, but will reward the patient investor willing to take a risk. Part of the reason is that the commodity price story looks likely to be a long-term one: plenty of ups and downs but, I suspect, more of the former. Returns from major markets are now settling down into what I think are more sustainable levels. The 20 per cent plus rises of 2003-05 that were seen in many countries are now a thing of the past, at least for this cycle. But the returns that we have seen during the first half of this year are, in my view, eminently sustainable.

The correction in May reminded us about the risks of investing in stocks. And we are not necessarily out of the woods yet - fingers crossed. Central bankers have a much tougher job ahead of them than they have had in recent years: they must be careful not to kill the golden goose. Of all the major markets, the US is the one that makes me the most nervous. And if the dinner tables of south County Dublin are anything to go by, the early signs of the end of the Irish property boom have now been glimpsed.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.