The global backdrop is likely to remain supportive of emerging markets in 2008, but the year ahead will likely be a more challenging one, according to Merrill Lynch.

ôEmerging equity markets are on course for another impressive year,ö Merrill Lynch says in a report. ôThe backdrop is likely to remain the dominant feature, with China and global growth still going strong, further commodity-price strength, and a weaker US dollar. All of this should lead to further outperformance, but not without risks.ö

Price returns for 2007 are currently annualising at 35%, following 52%, 22%, 30% and 29%, respectively, in the previous four years. Returns in 2007 from emerging market equities are beating modest gains in competing asset classes such as emerging market debt (up 6% so far this year) and developed market equities (up 8% so far this year).

Merrill LynchÆs bullish arguments include expectations that economic growth in emerging markets will remain strong. It forecasts a real gross domestic product growth o 8.0% and nominal GDP growth of 13.0% for emerging markets. ôIn our view, that makes the 15% consensus earnings per share forecast for next year achievable.ö

The key cyclical drivers for emerging markets equities are the boom in China, the bull market in commodities and the bear market in the US dollar, Merrill Lynch says.

None of these secular trends are over, according to the Merrill Lynch Economics group, and none are expected to meaningfully reverse in 2008. Until they do, emerging markets equity drivers are bullish and equities can, albeit ônervouslyö, ignore a G7 slowdown.

Despite Merrill LynchÆs optimism, it acknowledges that the risks going into 2008 are manifold. Risks include stagflation, the US dollar crisis, a global credit crunch, which are already worrying investors now.

In addition, Merrill Lynch is wary of emerging markets capital controls. Higher-than-expected inflation across the emerging, combined with higher-than-desired capital inflows could have two undesirable consequences for emerging markets -- capital controls and foreign exchange pegs.

The possibility of a European and Japanese recession is also a concern for Merrill Lynch. If Europe and Japan join the US in recession, then the likelihood of a bear market in commodities and a bear market in developed market equities would increase sharply. Neither would be good news for emerging markets equities.

ôThe year 2008 is clearly littered with risks, and no doubt equity markets will remain volatile, but we are convinced that the basic story for emerging markets is a good one,ö Merrill Lynch says.

Merrill Lynch believes the US dollar is near fair value, but that does not imply
it may not overshoot. ôA dollar crisis is a possibility, but not our base case.ö

The risks of a US dollar crisis are rising, and these include global growth slowing significantly and rising emerging markets inflation that would lead to various forms of policy tightening including capital controls.

Relative valuations have changed somewhat over the past year and has led Merrill Lynch to conclude that emerging markets equities have reached valuation parity with developed market equities but can certainly keep going due to superior earnings growth; emerging markets debt has become richer relative to US credit; and stable inflation in local markets over the past few years means that most of the big convergence stories have run their course.

By historical standards, emerging markets equities are not so cheap compared with emerging markets debt debt anymore, but the trend of equity outperformance û while likely choppier going forward û is unlikely to be altered in the next year, Merrill Lynch says.

Merrill Lynch says equity leadership is likely to remain with the Brazil, India, Russia, China (Bric) markets, resources, industrials, infrastructure, and consumer financials. It adds relative value supports resource stocks in BRIC markets and domestic demand plays in non-BRIC markets. It is also long on the Middle East.