The prospects for emerging markets are very appealing on a secular basis. The performance in the equity markets from countries in Emerging Asia to Latin America has been impressive for the better part of the last decade. A torrid pace of economic activity, growing per capita incomes, improved fiscal conditions, and overall global growth have helped to foster an environment for investments in these markets to flourish.
We had noted several months ago, however, that these markets were encountering some cyclical headwinds that would likely persist for some time, rending equity investments to a period of underperformance. The cause included concerns over rising food inflation and tightening monetary conditions to thwart the effects thereof. We also highlighted the increased risk of a policy mistake on the part of China, a country attempting to temper inflation and property speculation. China, after all, is the primary importer for the stuff emerging market countries take from the ground - food and rocks - making many emerging countries reliant upon a continuation of the commodity boom that has been underway for about the past ten years.
What should investors look for to identify a reentry to these markets? We believe there are a number of signposts that will help to increase the conviction in such a move. We first notice the delta in performance between global equities and emerging markets stocks has widened to near extreme levels. Generally speaking this has usually been at similar points in performance disparity that emerging market stocks rebound on both an absolute and relative basis. Next, while the current monetary tightening cycle is not over, we would look to the point where inflation begins to ebb either by a dimming pace to food inflation, or economic growth rates begin to slow. In either case it may herald a more dovish policy by central bankers which would relieve the headwinds to potential economic growth and better equity conditions. Finally, Chinese stocks are a leading indicator for China's success, or lack of, in grappling with its overheated economy. The Chinese stock market led the recent pullback in emerging market equities and may well move upward in advance. Therefore, we would monitor the Chinese market for evidence that the tightening cycle is nearing an end, forming the support for a resumption in emerging market equity leadership over their developed market counterparts.