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The recent sell-off in emerging market currencies and equities is part of a broader move that has seen the asset class heavily underperform developed markets since mid-2012. Part of the underperformance can be attributed to disappointing economic performance, as actual growth in the emerging markets has come in much lower than broader consensus expectations. This has occurred while economic momentum in the developed world has seen an improvement, as the European, Japanese, and U.S. economies have all shown better performance. Another reason for the recent EM underperformance is related to the fact that several emerging countries have recently experienced elevated political tensions and upheaval, reminding global investors that governance and political stability are still relevant in assessing the potential for returns in emerging economies.

If slower growth and political headwinds weren't enough of a challenge for EMs, an additional complicating factor has been the beginning of the unwinding of extraordinary stimulus measures in the world's largest economy. As U.S. monetary policymakers have gained more confidence that the health of the domestic economy is on an improving trend, they have started to reduce the monthly amount of securities purchases by the Federal Reserve. This has led to a notable pick-up in U.S. bond yields, and a change in the prevailing liquidity environment, negatively impacting the relative attractiveness of EM assets. Several emerging countries have experienced large currency, fixed-income, and equity market sell-offs, as well as sustained foreign capital outflows. While some countries have been hit much harder, aggregate equity and currency valuations in the EMs have become much cheaper today than 18 months ago in absolute and relative terms.

EM Distinctions

It is important to differentiate between EMs most at risk from capital outflows and volatility, and those that are relatively more shielded. In today's environment, we prefer EMs that are running solid fiscal positions, have balanced or positive external account positions, and are attractively valued. These countries include South Korea, Mexico, China, Chile, Colombia, Taiwan, and Malaysia. These economies are less in need of foreign capital to sustain their economic growth momentum, and have more economic management tools available to them versus countries that, because of their weaker positions, are forced to hike interest rates and sharply correct their budgetary and current account deficits in order to encourage foreign capital to stay.

The foreign capital dependent countries that are forced to undertake painful tightening measures will see the impact of their actions manifest themselves in much slower near-term economic growth as borrowing costs surge and domestic demand adjusts to lower currency foreign exchange rates. In order to become more positive on the investment case for this group of EMs, we would like to see two things. First, to see evidence that the economic cycle in these countries is bottoming out and the worst of the economic deterioration is behind us. We believe that economic fundamentals in these countries likely have more weakness ahead. The second precondition relates to the liquidity environment and the ability of these countries to continue to attract capital while undergoing macro adjustments. Specifically, this would require more evidence that the removal of monetary accommodation by the Federal Reserve is no longer posing a large headwind to the funding needs of these countries.

Upcoming Elections

Interestingly, the countries that are running the worst fiscal and external deficits are also those experiencing heightened levels of political uncertainty. Several (Turkey, India, Indonesia, South Africa, Brazil, Thailand, Hungary) have important elections in the next year. With economic governance issues at the forefront, election results will be key in determining how their markets perform in the year ahead. While we are cautious on the prospects of these countries today, and prefer those exhibiting more solid macro-fundamentals, we do believe that several real investment opportunities might crystallize more broadly across EMs later this year as poll results come in and new governments announce their policy agendas. With valuations cheap and recent investor sentiment turning more negative there is opportunity for new administrations to come in and launch reform programs that would improve the investment environment and economic growth momentum.

Opportunities Ahead

We believe it is important to be selective in EMs, focusing on countries that are less at risk of capital outflows and economic volatility. As elections in several important emerging economies take place later this year, the opportunities may broaden. While political developments in the EMs will certainly be important in guiding our asset allocation decisions in the year ahead, the global liquidity environment will also be an important consideration for us in assessing the attractiveness of opportunities. If the withdrawal of extraordinary stimulus measures in the U.S. proceeds as expected, we would like to see the markets become more comfortable with the prevailing liquidity environment before sizably increasing our positions in emerging market countries.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Emerging Markets: Distinguishing Opportunities