The recent Middle East turmoil coincided with what looked like an emerging-market exodus. The MSCI EM index is down 5.2% year to date while the MSCI World is up 4.8%. In the two weeks ending Feb. 9, investors pulled $10 billion out of emerging-market equity funds, according to fund tracker EPFR Global, while continuing to plow cash into developed-market equity funds. The resignation of Egyptian President Hosni Mubarak may ease some regional jitters, but it probably won't reverse the trend.
The shift out of emerging markets wasn't a traditional pullback from risk to safety; instead it was a rotation of risk appetite. Emerging markets face big challenges after their strong rebound from the crisis: inflation has surged higher, fueling concerns that some central banks, fearful of high capital inflows and currency appreciation, are behind the curve in tightening policy. Meanwhile the U.S. growth outlook brightened last year, and there is further room for growth without rate hikes: a positive mix for equities.
This rotation better explains the recent strength of the dollar than its safe-haven status. Plus, the picture across emerging markets isn't uniform: while Indian stocks are down 13.6%, Russian stocks are up 6.3%, reflecting the appetite for commodity-producing nations. Appetite for emerging-market external debt remains strong, with a record $42 billion of issuance in January, J.P. Morgan notes, of which 75% came from corporates.
There is a limit to how far this rotation might go: the greater risks still lie in developed economies. At least central banks in India, Indonesia and China can raise rates in response to inflation pressures without fear of a financial meltdown; by contrast, in the U.S., U.K. and euro zone there are concerns over the effect even small rate hikes may have on still fragile banks, highly-leveraged consumers and debt-laden sovereigns.
In price/earnings terms the MSCI World and EM indexes trade fairly close to each other and have converged over the last 10 years, Barclays Capital notes. For the moment, developed markets appear better value because they are at an earlier stage of the business cycle. But longer term, the better demographics and higher growth potential of emerging markets should ensure that portfolio flows rotate back again.
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