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Beware the siren call of emerging markets

Exciting growth is enticing, but there are pros and cons to investing in the new economies – and it pays to tread carefully.

The story of emerging markets is a seductive one. They are go-get-'em economies, growing at a staggering pace, set to speed past the moribund West in little over a generation. What's more, the main emerging markets of Brazil, Russia, India and China (Bric) have massive populations, growing middle classes and, crucially, young demographics. We all know by now the narrative, and for investors, even usually cautious ones, emerging market fund investment seems the ultimate no-brainer. No wonder the Investment Management Association reports that emerging markets are currently one of the most popular areas for private investment.

But as the deadline for investment in this year's Individual Savings Accounts draws ever closer – investors have until 5 April to put up to £10,200 in an ISA and secure the tax-free status of any growth – there is a note of real caution that needs to be struck. Not all, it seems, is plain sailing in emerging markets and investors should be acutely aware that many of problems blighting the West at present are at play in the emerging economies, potentially putting investment at risk.

Rising inflation is one of the key areas of concern. "Inflation is the price of strong economic growth and the chasing of commodities," said David Kuo, a director of investment information site Fool.co.uk. "China's economy is growing at around 9 per cent – its inflation rate is about 5 per cent; India is growing at about 8 per cent – its inflation is 9 per cent. Provided businesses can raise prices in line with inflation then profit margins and investor returns can be protected."

And inflation may not be a short-term challenge to emerging markets. Commodity price inflation is, according to Phil Poole, HSBC's global head of investment, likely to be the "economic story of the next 10 or 20 years. The effects on personal incomes in emerging market economies are greater as food and fuel take up 60 per cent of everyday spend."

Higher petrol and, in particular, food costs are fuelling political instability in the Middle East and potentially beyond, and this in turn can have a major effect on share values.

Turkey, an emerging market star, has, for instance, seen nearly 20 per cent wiped off its stock market as a consequence of the Arab Spring political instability. Whereas share prices in Western stock markets have, as yet, not been as affected.

"High oil prices will be a big drag on growth in Asia but, in a way, a Bric fund can act as a bit of a long-term hedge against the ill effects of commodity inflation. In Brazil and Russia you have two exporters of commodities, while in India and China you have two consumers," said Mr Poole. "More generally, there is a lot of volatility at present because it seems that one week's headlines reflect on the risks of emerging markets – such as inflation and instability, while another focuses on the rewards – high growth and burgeoning domestic consumption."

Jeff Chowdhry, F&C's head of emerging equities, says it is wrong to look at the dire headlines for the Middle East and inflation as purely emerging-market issues: "The situation in Bahrain, for instance, is worrying because of the Saudi Arabian involvement and the importance of Saudi Arabia as an oil producer. However, this is a risk for all markets."

But Mr Kuo highlights other areas where emerging markets may not come up to scratch: "For a start, corporate governance, which may not be of the same standards that we expect in the West. Closely related is accounting practices and transparency. There is also currency risk, which should not be underestimated. Vietnam devalued its currency by 8.5 per cent this month. So assets denominated in dongs would be worth 8.5 per cent less."

What's more, although growth rates can be exciting, this doesn't always feed through to share prices, and firms may not be used to paying dividends. "It's interesting that China and India have seen rapid economic growth over the past 10 years but returns for shareholders have been similar to those in developed Western markets," said Mr Poole.

However, the ultimate lure of emerging markets may well be that they aren't Western, burdened by debt and set for interest-rate rises: "In the next 12 months, people will be more worried about developed markets because of the need for interest rates to go up from their current historic lows." Mr Chowdhry said. "The emerging markets have started monetary tightening and will be in a better position as a result. In our view, people should be looking to switch from developed markets back to emerging markets."