Emerging markets are hard work for investors

The MSCI Emerging Markets Index has made up most of the ground it lost during its summer swoon. And September marked the first month in six that more money flowed into emerging market equities than flowed out. Still, don't expect a roaring rally.

The commodities supercycle has ended now that China is slowing. And while the US Federal Reserve has delayed easing up on money-printing, "the direction of travel" for US yields is up, says Fidelity's Tom Stevenson in The Sunday Telegraph, as markets begin to anticipate monetary tightening.

Higher interest rates in the US drag up emerging market rates too, and draw money away from developing states as the relative appeal of these risky assets dwindles.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Capital flight is worst for economies with current-account deficits. They spend more abroad than they take in from overseas, and depend on foreign capital to cover this external deficit. "The past five years' positive capital flows, appreciating currencies and falling interest rates are about to go into reverse."

The receding tide has uncovered structural problems that were ignored by both governments and investors during the good times, but continue to hamper countries' growth potential.

Take India, says Victor Mallett in the FT. Pervasive red tape means it takes years to acquire land for factories and projects, while onerous labour laws deter hiring. This weakens manufacturing, so India's industrial imports are high.

That in turn widens the current-account deficit, making India's economy all the more vulnerable to foreign capital exiting. Meanwhile, slow developed world growth means tepid emerging market export growth. The International Monetary Fund's 2013 emerging markets growth forecast is now 4.5%, down from 5% in July.

But none of this means investors should flee the asset class. Emerging markets have reduced their foreign currency debt in recent years and built up their foreign exchange reserves, so they are better able to withstand a slump in their currencies amid fleeing foreign capital. And in many cases the mounting headwinds are in the price.

The MSCI is on a wide price/earnings discount to developed markets. Making money in emerging markets in the next few years will be harder than in recent years, but not impossible. We still think Brazil, Vietnam, Mexico and the Philippines are among the best bets.