The benchmark emerging market index is in negative territory, having fallen more than three quarters of a percent
London: A month into 2011, one of the biggest swings in asset flows has been the outperformance of previously lagging developed market equities against once red-hot emerging ones.

The chances are that this rotation by investors, encouraged by shifting valuations, inflation concerns and growth spurts in some developed economies, will remain in place for a while -- perhaps six months -- but it is not likely to become a permanent fixture.

Nothing has happened to dilute the overarching view that emerging markets are a long-term, strategic growth story, albeit with somewhat heightened political risk -- as is now being seen in Egypt and Ivory Coast.

Standard & Poor’s cutting of Japan’s sovereign debt rating on Thursday, meanwhile, was a stark reminder that, in contrast to emerging economies, many developed markets continue suffer from government bank balance problems.

But for the time being, the tale of the tape is clear -- the flows are into developed markets and away from emerging.

So far this year, MSCI’s developed market stock index has risen a healthy 3.2% -- healthy in the sense that in the highly unlikely event this rate continues, developed market stocks would have the best compounded gain in at least 40 years.

The benchmark emerging market index, however, is in negative territory, having fallen more than three quarters of a percent.

Individual country indexes show the same pattern. The US S&P 500 is up more than 3% for the year while India’s BSE Sensex has lost around 10%.

The outperformance goes further. On a day-by-day basis last year, developed markets outperformed emerging markets on just 47% of occasions. So far this year, they have done so around 63% of the time.

And in terms of beta, a gauge of how a security reacts to moves in the market, emerging markets are moving closer to being in lockstep with developed markets -- meaning that at the moment there is little to be gained for the extra risk they may carry. Emerging market beta is currently close to 1.0, compared with 1.8 about five years ago.

Buggins’ Turn

Three things have brought this about and the issue for investors is how long each will remain a driver.

First, the popularity of emerging markets has made them a very crowded trade, meaning that prices have arguably got ahead of themselves.

“They had a good run over the past couple of years and the valuations are now looking more full,” said Jason Hepner, investment director at Standard Life Investments.

Second, as a result of their recent growth, many emerging markets are coming up against strong inflationary headwinds which are prompting central banks to enter a tightening cycle.

Food price inflation, a growing issue, is likely to have more impact on emerging markets than on developed ones.

Credit Suisse estimates that food represents about 34% of an Asia ex-Japan consumer price basket. In the United States, it accounts for less than half that. Thirdly, some leading developed economics, particularly the US and Germany, are showing strength.

Fund flow analysts EPFR Global say that the week up to 21 January was the sixth of net inflows to US equity funds that they track out of the past seven, amounting to total net inflows of $17.3 billion.

It compares with net $49 billion outflows from the sector in 2010.

Six Months

So will it last? The indications are that it won’t and that most of the embrace of developed markets has been tactical, a short-term move to grab an opportunity.

Goldman Sachs, for example, has been telling its clients to emphasis US and Japanese stocks in the first half of the year and to go back to emerging markets (along with European) in the second half.

“A cyclical slowdown in parts of EM driven by tighter policy is a concern but the secular trends and the growth leadership of EM is not in doubt,” Peter Oppenheimer, Goldman’s head of European portfolio strategy, said in a note.

There is also a likelihood that some of the factors putting investors off emerging markets at the moment will reverse.

William De Vijlder, chief investment officer at BNP Paribas Investment Partners, reckons inflation pressures will ease in emerging markets along with uncertainty about monetary policy, in part because there is little evidence of China overheating.

Six months should bring down the cost of emerging market equities versus developing as well.

“The appetite for emerging should pick up again. The relative valuation should by then have improved,” he said.

The trigger may be the developed economies. If they slow -- and US recent data has been disappointing, not to mention Europe and Japan’s fiscal problems -- emerging will start to look better more quickly.

If, on the other hand, the US economy takes off, emerging markets might take a back seat for a bit longer.