Why Emerging Markets Have Wind at Their Backs

Emerging markets aren’t a haven—but they look like a compelling alternative to the bigger concerns that still lie in developed markets

By Richard Barley

One month on from the Brexit vote, and one week after the Turkish coup attempt, emerging markets show no signs of flagging. In fact, the surprise success story of the year appears to be gathering momentum.

Emerging-market stocks are handily beating their developed peers, with the MSCI Emerging Markets index up 9.7% in the year to date, versus 2.6% for the MSCI World. Away from the Turkish lira, currencies have retained their poise: the Russian ruble is up 13% against the dollar, the Brazilian real 21% and the South African rand 9%. Bonds are proving no slouch: J.P. Morgan JPM 0.33 % ’s EMBI Global sovereign bond index has returned 12.5%; its local-currency peer, the GBI-EM nearly 14%.

What were headwinds for emerging-market investors are turning into tailwinds. The performance in stocks marks a departure from near-continual disappointment since 2010. The rally started in part because investor sentiment toward emerging-market assets was extremely poor: a small reversal in flows could shift the dial. Now the taps are open: in the week to July 20, retail investors put $10.2 billion into emerging bonds and stocks, the second-largest amount on record, J.P. Morgan notes.

Growth, meanwhile, could be looking up. The latest International Monetary Fund forecasts brought downgrades for developed economies, but not for emerging markets: the growth gap, which has been narrowing since 2011, is set to widen again. Fund manager NN Investment Partners says that its growth momentum indicator, based on data from 20 leading emerging-market nations, has turned positive for the first time since 2014.

Meanwhile, what is bad news for Turkey, with the lira down more than 5% year to date and its credit ratings under pressure, could be good news for other high-yielding emerging markets, Citigroup C 0.11 % strategists note. Turkey’s troubles are country-specific: that argues for rejigging positions within emerging-market funds, not pulling cash out of the asset class altogether.

Of course, risks remain. But one worry—tighter monetary policy from the U.S. Federal Reserve—doesn’t look quite as scary as it did. Even though Brexit now seems unlikely to deliver a Fed on permanent hold, U.S. policy makers are clearly moving gradually. And many emerging countries have used the time since the so-called taper tantrum of 2013 to improve their positions.

China remains the elephant in the room—on several fronts. Chinese growth is vital for emerging markets and the globe, and the imbalances that the economy has built up, including high corporate debt levels, continue to be a concern. A reassessment by China of its currency policy, too, would shake markets. But this is a threat to global investors, not just emerging markets.

The bigger concerns for investors still lie in developed markets, where the aftermath of the financial crisis is undermining long-held political assumptions. Emerging markets aren’t a haven—but they look like a compelling alternative.

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