The outlook has recently begun to turn, supported by the Federal Reserve’s ‘no-taper-just-yet’ decision. Broad emerging market equities are also now at a significant value discount to developed equities. So where do emerging markets go from here?

Recent liquidity challenges have reminded everyone that looking at the fundamentals of each country is important. Differentiating between countries is key and investors are taking a more nuanced approach.

A strong foreign exchange reserve and current account surplus suggests stronger support of the local currency and lower dependencies on external financing.

Conversely, declining foreign exchange reserves and a current account deficit can prove toxic for emerging economies, especially in an environment of lacklustre growth and rising inflation.

The recent performance in Indonesia, which has been hit by a combination of an unexpected inflation spike, substantial exposure to foreign investment and a rapid run-down in foreign reserves, is an example of this.

The central bank there has attempted to protect the rupiah by hiking rates by 1.5 per cent in two months, but this is straining its already fragile economic growth.

In the short term, emerging markets are starting to see a cyclical upswing. They have been supported by growth in developed markets and the Federal Reserve’s current stance.

Looking beyond that, structural challenges and risks such as a stronger US dollar and credit booms could yet spell trouble for emerging markets, especially those relying on external funding.

South Korea has attracted the most inflows of any single emerging market country so far this year. It has a current account surplus of 5.64 per cent of GDP, which is among the highest in the emerging markets.

South Korea has also benefited from its strong trade ties with the US and other emerging economies. Taiwan has strong trade links with the US technology industry and stands to benefit from the sector’s growth. It also has a very favourable current account surplus of 10.96 per cent of GDP.

Towards the end of the year there should be more clarity to come on the balance between reform and growth in China. This will come at the annual party plenum in Beijing, which is the first full-year wrap for the new government. Investors are likely to position themselves favourably beforehand, given data has recently improved.

As a result there is a tactical opportunity in Chinese equities, although long-term reservations remain about the country’s transition to a different growth model.

Brazilian equities look attractive on a valuations basis. They trade at the lowest valuation ratio in Latin America, and are set to benefit from the recent pick-up in Chinese data, given Brazil’s export links to China.

In the near-term, local debt could outperform as emerging market currencies reverse some of their recent losses in the immediate aftermath of Fed-driven sentiment rally.

Beyond that, external debt still looks better positioned within the emerging market space on risk-reward characteristics, given local rate and foreign exchange volatility.

Stephen Cohen is head of investment strategy at iShares

WHAT’S THE OUTLOOK?

Andrew Johnston, fund analyst at Brewin Dolphin, says:

“Emerging market equities saw strong inflows at the start of October, with increased investor confidence and a view that China, which has seen a healthy jump in industrial profits, may avoid a hard landing.

“Developed market equities, on the other hand, saw fairly significant outflows, largely as uncertainty surrounding US tapering and deadlocks in Washington over the budget and debt-ceiling played on investors’ fears.

“Regardless of the short-term moves for those who remain committed long-term emerging market investors, and who are keen to access the growing domestic consumption story, we view vehicles such as Fidelity’s Emerging Markets fund as a great way to access the asset class – especially given its focus on quality companies and historically defensive return profile.”