After China and India: The next hot markets

Rising interest rates and volatility are likely to slow the rally, but some analysts still see upside for overseas markets.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- For years investors have piled into economies like China and India in search of outsize returns.

But after so much white-hot growth, these so-called developing countries are starting to mature, spurring talk that higher inflation will bring an end to the emerging markets boom.

The bull run in emerging markets "began at a time of deflation and is likely to end at a time of inflation," Merrill Lynch global emerging market strategist Michael Hartnett wrote in a note last month.

Treasury yields have broken out above 5 percent, making government bonds more attractive relative to stocks - especially some stocks in risky emerging markets. And the troubles in the subprime mortgage sector have rattled investors worldwide, which could reduce the amount of money flowing to higher-risk investments.

Now though, with China and India maturing, some analysts say other markets in Asia, Europe and Latin America could be better bets for investors seeking more exposure to global growth, and bigger returns. Beware, though: these markets are risky, and subject to wild swings up or down.

Emerging markets have been on a tear for the past five years. The benchmark Morgan Stanley Capital International Emerging Markets Index is up 15 percent this year with a five-year annualized return of about 28 percent.

This year's returns may not be as stellar, and volatility is likely to shake up the market, according to Hartnett. "But a bull market it remains, and a bubble in 2007-08 is more likely than a bear market, in our opinion," he wrote.

Countries like India and China, while they are maturing, still are growing at a heady pace, analysts said. India has made infrastructure investment a top priority over the next several years, which will create investment opportunities, according to Richard Portes, professor of economics at London Business School.

And while many are worried that China's sizzling stock market could be a bubble ready to pop, the Chinese economy keeps humming along, with growth expected at 10 percent this year, according to International Monetary Fund estimates.

"I see the most promise in Asia, primarily in China, because consumption and growth have all been so strong. There's no reason to think growth is going to be shattered," said Donald Elefson, manager of the Excelsior Emerging Markets Fund.

There are some worries that rising labor costs in these countries will fan inflation worldwide, but Portes said those concerns are overblown. "Wages are rising, but productivity is rising just as fast," he said.

Recent jitters have made investors more cautious, but the fundamentals supporting emerging markets remain in place, according to Andrew Howell, Citigroup's chief strategist for emerging markets. Commodities, for instance, keep on booming.

Now the key issue now is valuation. Whereas four years ago, emerging market stocks could be bought at a 65 percent discount to developed markets, today the discount is roughly 10 percent or less, according to Howell.

"These aren't discount assets. The environment is great but a lot of that is already priced in," he said.

He favors markets that aren't in the spotlight like Romania, Ukraine and Kazakhstan. These markets are less widely followed and hence there's more intrinsic risk, but overall they have the potential to offer higher returns, Howell said.

The emerging markets rally has been helped by years of low interest rates, which have helped keep volatility low, according to Nick Chamie, head of emerging markets research at RBC Capital Markets in Toronto.

But "with interest rates on the way back up, risk premium will creep up and people will become more selective about their investments," he said.

Nonetheless, growing markets overseas still offer a diversification benefit, said Chamie, who focuses on investing in emerging market bonds and currencies.

His picks include countries like Brazil and Turkey, whose economies are slowly being structured to be more competitive internationally, and Russia - which has amassed massive foreign exchange reserves amid the oil boom. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.