The last few months have been unkind to emerging markets. After a long period of outperformance, it was perhaps inevitable the asset class would pause for breath.
There have been two main reasons why the rally has stalled. The first is a growing concern about inflation and what central banks are going to do to stop it. Indian authorities recently tightened monetary policy in an attempt to tackle higher food and fuel prices, prompting a sharp sell-off in the country’s stock-market. China and Brazil have not been far behind.
The rising price of food and other commodities helped precipitate the unrest in North Africa and the Middle East and the rise in the oil price is further stoking inflation.
With improvements in developed market economies, investors are increasingly risk-averse, pulling money out of emerging markets in favour of their developed counterparts. In the five weeks to the end of February, emerging market equity funds suffered outflows of $21bn – a dramatic reversal since the latter part of 2010.
But there are many reasons to remain invested in the asset class. The market’s response to monetary tightening appears an overreaction. At this point in the cycle, the measures are exactly what these economies need to prevent pain further down the line. Interest rates in most emerging markets are low by historic standards and any increase should be seen as a move back towards more normal levels.
Much of the developing world is in robust financial health. Unburdened by deficits, many emerging market governments do not have to worry about austerity measures or budget cuts and have scope to spend their way out of the downturn – an option not open to the West.
This comparative lack of debt is mirrored in the financial positions of emerging market companies and consumers, providing a fillip to economic growth. GDP continued to power ahead last year at levels unthinkable by the standards of developed economies.
From an investment perspective, volatility is likely to persist in the short term. Investors remain risk-averse but markets have focused on the short term rather than on the fundamentals that will drive the market over the medium to longer term.
From this perspective, emerging market equities look well placed. Compared with prior financial crises, developing countries are in a much stronger position. Indeed, this time around, the world is relying on the likes of China and India as the drivers of global growth. As a result, the recent sell-off provides an excellent opportunity for longer-term investors.
Natalie Burnand is investment director of multi-manager at Swip