Montreal, Canada

There’s nothing hotter these days than emerging markets.

Emerging markets are all the rage as foreign direct investments surge, IPOs boom across the region and currencies muster their single best calendar year of gains against the dollar in years. Credit spreads, which measure the riskiness of bonds against government securities, continue to narrow and, in some cases, hit new highs as yield spreads contract.

For example, benchmark US$ Colombian 10-year government bonds yield just 4.07%, an amazing 150 basis points more than Treasury bonds. Colombia? Really?

Mexico is another example of rapid yield compression in what was once perceived to be a risky asset. Mexican 20-year government paper pays an effective yield of 5.07% , just 107 basis points over Treasury bonds. That’s an interesting spread, and, perhaps, overly optimistic.

Mexican GDP revenues have already peaked amid peak oil production in the once-lucrative Cantarell oil fields. I wonder where Mexico will find new revenues – further challenges by rising gang wars across the country adversely impacting tourism. Mexican debt is overvalued.

Emerging markets are so hot that Brazil recently boosted tariffs for the second time on foreign portfolio flows into the domestic market while Thailand announced similar measures last week to control the baht’s appreciation.

Through October 18, the MSCI Emerging Markets Index has gained 12.4% compared to 5.1% for the MSCI World Index. The CRB Index of 19 raw materials (see above) hit a two-year high last week but remains more than 35% off its all-time high in early July 2008.

For the most part, the economic renaissance of emerging markets over the past decade is largely attributed to the secular bull market in raw materials. This relationship is a powerful correlation driving fund flows and economic performance across the asset class. That’s because most of these economies – especially in Latin America, Indonesia, Malaysia, Russia and South Africa – derive a significant share of their GDP revenues from natural resource exports.

With commodities on a tear since 2002, it’s no wonder some of these former economic basket-cases have morphed into economic giants recently with bulging foreign exchange reserves, rising trade surpluses and, in many cases, budget surpluses. But what happens when the bull market in commodities finally ends?

Historically, commodity bull markets have lasted anywhere between eight to fifteen years in duration. This one, which began in late 2001, is approaching its ninth year.

And there’s still plenty of gas left in the tank as a combination of compelling macro forces drive the rally to new heights; the weak dollar, gold rising vis-à-vis all currencies since 2005, super low interest rates and Chinese consumption all continue to attract investors and speculators alike.

Make no mistake about it: Once the commodities bull market ends, most emerging markets will succumb to new challenges, including a new crisis in their balance of payments, declining currencies and an evaporation of years of fiscal surpluses. It’s happened before and it will happen again. Many emerging markets have grown addicted to soaring commodities prices. And parties don’t last forever.