Will submerging economies rise again?

Emerging markets have struggled to make gains this year compared to their developed-market peers. But hope could be on the horizon.

This year has been a bad one for emerging-market (EM) assets, say Christian Keller and Koon Chow of Barclays. At their mid-summer lows, EM shares as measured by the MSCI Emerging Markets Index had fallen by around 17% in US dollar terms since the beginning of January.

While subsequent months saw a partial recovery, "investors have generally remained sceptical" and markets have certainly not recovered all their losses. The MSCI Emerging Markets Index is on course to finish the year down by around 6%, compared with a 19% gain for developed markets.

Given that emerging economies have "spent years as favoured spots for investment for asset managers, industrialists, cab drivers and monkeys throwing darts", this represented a sudden and unsettling fall from grace, says The Economist. The principal reasons were twofold.

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First, average EM growth, which had been slowing for several years, dropped to an underwhelming 4.5% in the middle of 2013. This may have made it clear to investors that many assumptions they made on the back of the "decade-long boom" of the recent past were overoptimistic.

Second, the US Federal Reserve's plan to wind down (taper') its quantitative easing (QE) programme warned of an imminent end to the tide of cheap money that has helped to buoy riskier assets of all kinds. That provided a trigger for the "rout" that followed.

The good news is that, following the summer sell-off, EM stocks enter 2014 with more attractive valuations relative to developed markets, say Keller and Chow. Economic growth seems to be picking up too. This suggests that emerging markets are likely to outperform in the near future.

Governance is key

However, while there may be scope for a broad relief rally in EMs in the near future, it seems that investors are slowly abandoning their tendency to treat all markets as the same investment story. In particular, "structural reforms are becoming an increasingly important differentiator between EM economies", say the economics team at Deutsche Bank.

New policies announced after a meeting of China's top policymakers in November are impressive and there is already "convincing evidence that these are likely to be implemented without delay".

Meanwhile, "Mexico continues to lead the way in Latin America". Conversely, in Brazil, India, Russia and South Africa there is less sign of broad progress in tackling infrastructure bottlenecks and other issues that are holding back growth.

This more discerning approach has meant that "the best-run economies notably South Korea and Mexico have been safe havens throughout 2013", says The Economist; Korea, for example, is up by 1% in US dollar terms this year (Malaysia and Taiwan are also in the black).

Meanwhile, investors were especially keen to flee the "fragile five" of Brazil, India, Indonesia, South Africa and Turkey large economies that have been running worrying current-account deficits. These markets are down by between 8% (India) and 27% (Indonesia) to date. The implication is that good governance is likely to be crucial in determining which EMs cope best as the boost from QE fades away.