The headwind of rising U.S. interest rates may be about to ease, but investors are still facing tighter money across the board and some are beginning to sound warning bells about emerging markets as a result.

Cheap money and improved fundamentals, it is argued, have driven investment into emerging market stocks and bonds to the point where the rewards may not be worth the risks.

Britain's Legal & General Investment Management, for example, believes the cheap money has dragged risk premia in the riskier equity markets down to unappetizing levels. It says the better opportunities are in boring markets.

Julien Garran, the fund firm's head of asset allocation, says his focus is now moving away from emerging markets to less-exciting developed ones, particularly in Western Europe.

He offers as evidence two, perhaps surprising, findings. First, implied equity risk premia on British, U.S., French, Italian, Norwegian and Swedish shares are all higher than those of countries such as South Korea, Russia, Hungary and Mexico.

Second, on a relative basis, trailing price-to-earnings ratios in the Czech Republic, Hungary, Poland, Russia and Turkey are all higher than in Britain, and those in South Africa and Pakistan about the same.

The first comparison suggests that investors are being paid less to hold relatively risky assets than safer ones; the second that stocks in the riskier countries are relatively expensive.

In a similar vein, another British firm, F&C Asset Management, has placed emerging markets toward the bottom of its stock pile.

Asian equity valuations look full, it said in its latest outlook, and other emerging markets look poor compared with other regions, such as the United States.

Given our view that volatility will rise in 2006 and earnings optimism will peak, we prefer to be in more defensive markets, F&C said.

A GREAT RUN

There is little evidence from the markets themselves that this more bearish sentiment is taking hold yet.

MSCI's main emerging market index is up more than 19 percent year-to-date after a more than 30 percent rise last year. It has gained more than 6 percent this month alone.

Whether as cause or effect, there have been huge investment flows into emerging equity funds.

Flow-tracker Emerging Portfolio Fund Research (EPFR) says there were nearly $2 billion net inflows into such funds in the week that ended on April 12, lifting the year-to-date net inflow total by more than 12 percent.

In all, emerging market equity funds tracked by EPFR have attracted around $26 billion in net inflows this year compared with $8.3 billion for European funds and just $2.4 billion for U.S. equity funds.

At the same time, demand for emerging market government debt as tracked by the JP Morgan Emerging Markets Bond Index Plus has driven the yield spread over benchmark U.S. Treasuries to the narrowest on record, around 185 basis points.

The concern is that the run that has made these stocks and bonds so popular has been fueled by easy money which is now set to be less easy. The Fed may be about to stop, but its higher rates will be felt and others are set to start tightening.

Less liquidity could hurt emerging-debt assets, Citigroup Private Bank said earlier this month as it warned its wealthy clients away from the asset class.

At the same time, it cut back its recommended exposure to emerging market equities to a neutral stance.

MORE CHOOSEY

Liquidity fears have already had their impact. European Central Bank tightening and the Bank of Japan's move away from ultra-loose monetary policy caused a widening of spreads and a sell off in emerging market equities in March.

The markets recovered rapidly, however, which is what some investors expect will happen if another correction sets in.

There may be bigger pullbacks then the ones we've seen, but it won't last, said one hedge fund manager, who asked not to be named.

The key for the asset class may be that investors start to get picky about what they buy.

Countries with solid current account surpluses and heavy commodity exposure have a better chance of riding any bond problems than countries where finances are less in control.

The same search for quality likely goes for companies, with investors turning from a regional approach to a strategy based more on stock picking.

Previously it was a rush to buy anything, said Michael Hartnett, Merrill Lynch's chief global emerging markets strategist. Now I think that quality will stand out.

(Additional reporting by Pratima Desai)

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