Over the past six years, few investment themes have invited such gyrations in sentiment, or generated so much contention, as the emerging markets. After an initial sell-off during the worst of the 2007-08 financial crisis, they clearly outperformed through 2009-11. 

Where previously emerging markets were assumed to be inherently riskier than developed markets, some began to suggest that the financial crisis revealed the opposite – Asian and Latin American economies had built strong fiscal positions in response to their own crises in the late 1990s, which were now the envy of the developed world. At the same time, the growth of intra-emerging market trade suggested these economies could continue to grow, ‘de-coupled’ and free from the drag of lower demand from the developed world. A year and a half of outperformance reflected a major re-rating of emerging market risk. 

But the outperformance of 2010-11 arguably reflected something different: an enormous dollar-funded carry trade that pushed valuations beyond what the fundamental re-rating could justify. As China’s GDP growth figures began to slide, rumours spread of strains in its credit system. Cracks appeared in the reform consensus from Brazil and Turkey, to Indonesia and Thailand. During the summer of 2011, emerging markets endured their first major sell-off since 2008. 

A year later, Mario Draghi’s “whatever it takes” promise extended the good fortune, even as the marginal global liquidity that had been pushing emerging markets skywards began to drain away. When outgoing Federal Reserve chairman Ben Bernanke announced plans to “taper” his quantitative-easing programme, a number of long-favoured carry trades suddenly unwound – and emerging markets were among the biggest. Particularly hard-hit were local currency emerging market bonds, reflecting that all was not necessarily well with those countries running high current account deficits and relying on a supply of US dollars. Meanwhile, peripheral euro-zone bond spreads continued to tighten, the US economy continued to heal, the S&P500 index kept reaching for all-time highs. 

In 2014, investors face a number of big questions about what to do with emerging markets. Most remain under-invested – in terms of global market-capitalisation weighting, but especially in terms of these economies’ contribution to global GDP. Three years of underperformance might suggest a good opportunity to close some of that allocation gap. But what if the correction has not run its course yet? What happens when global liquidity really starts to tighten? Can China’s authorities engineer a ‘soft’ unwinding of its bloated credit markets? 

Longer-term, it seems clear that the growth rates over the past 20 years are a thing of the past; economies have matured, wages have converged a lot with those of the developed world, and the ‘de-coupling’ phenomenon was never as strong as its advocates suggested. Have markets priced in a more realistic level of growth, or is there further to go? 

The fact that the dispersion in performance among different emerging markets has risen – in equities, bonds and currencies – suggests that investors are paying more attention to fundamentals today, rather than treating these regions as a single, undifferentiated asset class. And behind all this, there is the tantalising prospect that the frontier markets of Asia and Africa are in the same position that the emerging markets were in 20 years ago – and poised to post the same kind of growth over the next 20. 

Our supplement takes a step back and looks again at emerging markets in the round. Has the story changed, or have we merely turned the page into a new chapter?

Martin Steward, Investment Editor, IPE