Montreal, Canada

Since October 2002 when stocks hit a low in the first of two bear markets in the 2000s, emerging market equities have dominated global investing. That trend continues in a rough 2010 for most investors as major benchmarks struggle since April.

Since 2000, the MSCI Emerging Markets Index has gained 8.9% per annum compared to a loss of 1.7% per annum for the MSCI World Index of mature economies.

Emerging market bonds, unlike most stocks, have not suffered a decline this year as buoyant inflows continue to drive bond yields lower; in fact, no other investable bond index in the world since 1992 has outpaced emerging market debt. Only U.S. zero-coupon bonds (strips) come close.

The MSCI Emerging Markets Index is once again on top this year following big rallies last month in the BRICs (Brazil, Russia, India and China) and has surpassed the MSCI World Index in the total return column. In 2010, emerging markets are up a modest 0.20% versus a loss of 3.7% for major markets.

Emerging market stocks have beat major market equities every year world markets have posted a gain since 1999. In bad years, including major dislocations in 2002 and in 2008, emerging markets sank deeper than major markets but also bounced back much faster on subsequent recoveries.

Valuations, however, are not as compelling for emerging market stocks as compared to two years ago. Some “bubbles” are forming in China and Brazil.

According to Montreal-based Bank Credit Analyst (BCA), emerging markets now trade at about a 40% discount to major markets compared to almost 90% twelve years ago when the Asian currency crisis pummeled the sector. Still, a 40% discount is pretty attractive, especially when combined with superior growth rates, far lower net debt-to-GDP ratios and for the most, trade and budget balances in surplus, unlike the West.

Emerging market bonds remain expensive and should be avoided. The biggest bond markets in this sector – dominated by Brazil and Mexico – are overheating as spreads have crashed over the last several years. With several emerging market central banks now in the process of tightening the best strategy is to avoid domestic bond markets and over-weight equities. Inflation, not deflation, is a primary concern in these markets with the significant exception of China.

The primary trend for emerging markets remains bullish. In up markets, the asset class tends to provide greater alpha or excess return while in down markets they do fall harder than the major economies. The Fed has been a good friend to this exciting sector as the dollar has remained cheap and interest rates the lowest since the 1950s. Some “bubbles” are forming and others are in the process of being liquidated – mainly in Chinese real estate. Overall, the trend is bullish.