What can change the outloook for emerging markets?

She says: “Many investors took the view that with US equities doing so well, why bother with emerging markets? That can be seen in the flows out of the asset class in recent years.” 

In addition, Whiting acknowledges that higher US interest rates negatively impact the asset class, for reasons of both sentiment and fundamentals. 

The fundamental issue is that higher US interest rates increase the risk-free rate of return on some investments, via owning government bonds.

As the yields on those bonds increases, so the extra risk attached to owning emerging market assets looks relatively less attractive.

The second factor is that most emerging market economies and countries are unable to borrow in their own currencies, and instead borrow in dollars. 

Rising US interest rates mean the cost of repaying or refinancing this debt rises, leaving less capacity for those companies to pay dividends, or invest to grow their businesses, or economies.

Whiting says she believes the impact of a higher risk-free return has had a meaningful impact, but that the higher borrowing costs effect is “much softer” in terms of impact than has been the case in the past, as most emerging economies have broader domestic capital markets. 

She feels that while investors in developed markets debate the capacity for central banks to cut rates as a way to stimulate economic growth, “many of the emerging market central banks were ahead of their developed market peers in raising rates, and so have more scope to cut now.”

By raising rates ahead of developed market economies, many emerging markets were able to insulate themselves, at least partially, from the impact of dollar strength. 

David Jane, who runs a range of multi-asset funds at Premier Miton, is keen on emerging markets right now, particularly because he feels that the next stage of the interest rate cycle will be positive for the asset class. 

He says: “My basic hypothesis is we are in a higher-for-longer environment – rates and inflation. And also relatedly we are in a bull trend, higher for longer means higher returns, nominal at least.

"In the early stages, partly as a result of the auto bid from buybacks and index funds this has been driven by the mega-caps. But as things go on the margin flows are beginning to go elsewhere. You can see this in some of the recent moves in Japan, Korea, even H-shares; active managers are starting to reinvest gains in the magnificent seven into other places.

"This is understandable given the spectacularly cheap valuations available in some of these markets – we were buying huge yields that we above their P/E’s in Korea a month or so ago.

"I remain bullish because these markets have a long way to catch up from these levels."

The extent of emerging market underperformance relative to developed market indices is illustrated in the above chart, and is something Tim Lowe, director of emerging market equities at GAM Investments, attributes to investor concern about the outlook for China’s economy and market. 

He says: “Emerging markets have been dragged down by China, where loss of wealth has been overwhelmingly large. If you exclude China, emerging markets are doing better than industrialised economies excluding the US. For instance, the MSCI EM Latin America 10/40 Index exhibited impressive growth of 34 per cent last year.

"People generally opt for the easiest money. Currently that is in US government bonds, with 5 per cent yields. However, emerging markets have a more attractive risk/reward profile because they tend to capture greater upside when global growth improves.” 

That the broader emerging market is linked to the fate of China is demonstrated by that country’s equity market being around 25 per cent of the index, though it was as high as 40 per cent prior to China’s sell-off, but also because Chinese consumers tend to be substantial spenders in other emerging economies. 

Underneath the bonnet

Whiting says that while some of the economic data emerging from China does point to improved conditions, consumer confidence remains relatively weak because of issues within the property market. 

She adds that at the market level, investors may have been expecting a “big bazooka of fiscal policy response to stimulate growth, instead what we got is a series of smaller measures”.  

In contrast to the pessimism around China, Whiting says investors are now particularly keen on India. 

She says the price to book valuation metric at which the Chinese market trades is presently around 1.1, whereas the Indian market is 4.4. 

Emerging markets present a mixed bag.Seema Shah, Principal Asset Management

Her view is that the fundamentals of the Indian economy are strong, the “companies can grow into the current valuations, but are suitable for clients with the time horizon that means they can wait”.

Gaurav Narain, who runs the India Capital Growth investment trust, says the part of that equity market that may have had the greatest degree of “froth” is in the small and mid-cap area, but that valuations there have been impacted recently by regulatory action. 

He notes this may have removed some of the froth from that part of the market as investors ponder the impact of the forthcoming elections on the regulatory regime in that country. 

Seema Shah, chief global strategist at Principal Asset Management, says: “Emerging markets present a mixed bag. India remains on the pricier end, and China’s market is likely to continue struggling unless policymakers introduce new and impactful stimulus measures.

"However, investors should keep their eye on Latin America, which currently benefits from some of the most attractive valuations globally. When combined with its positive fundamentals, a strong investment case for the region is beginning to emerge.

"Global valuations undoubtedly are stretched, but a closer look reveals pockets of potential opportunity that can benefit from the constructive macro backdrop."

David Thorpe is investment editor at FT Adviser