Emerging and Developed Markets—Decoupling or a Reversion to the Mean?

Several factors have contributed to the drop in emerging market equities and to the relative strength in developed markets. One of the most obvious explanations can be seen in fund flows for the first two months of the year. Through the end of February, emerging markets saw outflows of $6.7 billion, the most of the 89 categories tracked by Morningstar. On the other hand, large-cap developed markets took in more than $25 billion.

Some of these directional flows can be attributed to beginning-of-the-year portfolio rebalancing. In addition, profit taking in emerging markets was surely at work as investors sought to lock in gains after a run of such strong performance. Moreover, many investors may have decided to decrease exposure to emerging markets or to increase exposure to developed markets because of relative valuations.

Due to their higher risk, emerging markets have historically traded at a discount to developed markets on a P/E basis. At the end of 2010, however, the MSCI EAFE and Emerging Markets indexes were trading at almost the same valuation—a rare occurrence.

While these factors surely have contributed to the reversal in performance trends, the key catalyst appears to be the jump in commodity prices and inflation figures as the global economy has continued to recover. Accelerating inflation has significant yet different implications for developed and emerging markets. Based on market reactions, the emergence of inflation has been viewed as a positive for developed markets, but as a negative for emerging economies. And that disparity is directly related to what has driven performance off the bottom—the vast differences in economic growth rates.

In the July issue of Investment Advisor, McAllister will expand on inflation’s impact on the global economy, and share his view on emerging markets trends.