If you think emerging market stock markets have had a blistering run this year, consider returns for investors deploying dollars.

Brazil’s benchmark Bovespa index has gained 76 per cent in the real, the local currency. But in dollars the gains amount to 139 per cent as the US currency has drifted to its weakest level in 15 months.

The surging Brazilian stock market reflects optimism about economic growth in the Latin American economy because it has ridden out the global downturn in better shape than most. But returns have been amplified for dollar investors because the real has gained 26 per cent against its US counterpart this year.

Analysts say it also results from a vast “carry trade”, in which ultra-low US interest rates have enabled investors to borrow in dollars and buy riskier assets, including commodities, foreign currencies and emerging market stocks. If US rates should rise, or fear creeps back into the market, a harsh reversal could be ahead.

“At some point down the road, if the dollar turns or if risk appetite deteriorates for a period of time, you’re going to find these trades all going the other way,” says Geoffrey Dennis, global emerging market strategist at Citigroup. Until then, investors are stampeding after the opportunity.

Emerging market equity funds have seen $64bn in net inflows so far this year, a record, according to EPFR Global.

In South Africa, stock returns in dollars are 56 per cent up this year, but only 23 per cent in rand terms.

Turkey’s stocks are up 86 per cent in dollar terms, but 79 per cent in lira as the local currency has gained.

In Chile, shares on the Santiago stock exchange have risen 77 per cent in dollars and 41 per cent in pesos.

A similar trend is apparent in South Korea, although not in Asian markets, where exchange rates are tightly managed, such as in China.

Developed markets have also seen their stock markets advance this year, but the gains have not been as pronounced as in emerging markets.

The relative returns reflect several trends. Emerging markets have generally weathered the financial crisis in better shape than the US, where government borrowing and a policy of loose money have not stanched widespread job losses.

US equities have also suffered two big bear markets this decade. The Standard & Poor’s 500 stock index, currently around 1,100, first reached that level in 1998.

The differing returns stem from the obvious fact that investors using dollars are profiting not only from the rebound in emerging markets, but from a cheaper dollar exchange rate when they cash out. The dollar index, which measures the currency’s performance against six others, is down 8 per cent this year.

With the Federal Reserve signalling no change to interest rates for at least six months and the US unemployment rate now surpassing 10 per cent, the carry trade could last for months.

But a foretaste of a potential reversal came last month after Brazil imposed a 2 per cent tax on short-term capital inflows to avoid bubbles and to ease upward pressure on the real.

The dollar staged a short-term comeback and the Bovespa index fell 11 per cent before recapturing most of its gains.

“We got an early warning in the last week of October,” says Henrik Pedersen, chief investment officer at Pareto Investment Management in London.

“It shows you how overweight the market became in the carry trade.”

(from www.ft.com)