Developed markets expected to be hit harder by rising oil prices

The emerging world recovered strongly from the global credit crisis owing to strong fundamentals and domestic demand-driven growth.

The emerging world recovered strongly from the global credit crisis owing to strong fundamentals and domestic demand-driven growth.

However, inflationary pressures have increased in several EMs, leading to policy normalisation and tightening measures in some cases.

Together with recent political unrest in parts of North Africa and the Middle East, this has led to some stock market weakness year to date.

While policy-makers in the emerging world will be keen to avoid the build-up of asset bubbles, they are unlikely to allow policy tightening to destabilise a sustainable recovery in the economy.

However, the risk of inflationary pressure and a bubble developing in the emerging world has heightened on QE being implemented in the developed world. This led to record inflows of $94bn into EM equities in
2010, although there has been a small reversal of this trend year to date.

While capital flows are supportive for returns, the prospect of strong capital inflows can have a destabilising effect on domestic assets and currencies.

Furthermore, in reaction to such strong flows, some EM economies have imposed capital controls to deter excessive foreign money.

While government intervention can provoke short-term volatility, the longer-term impact of such measures tends to be limited and currency strengthening can be expected.

Shorter-term headline inflation has seen an increase in certain markets, but core inflation remains subdued and output gaps exist in some markets. Furthermore, as developed-world GDP growth recovers, developed markets will face the twin headwinds of fading stimulus measures and tighter monetary policy – a phase the EMs will have already undergone.

Political unrest in MENA regions has unsettled EMs over the past two months. However, the unrest has taken place in countries whose markets are relatively insignificant in the context of EM benchmarks.

Should the unrest escalate to larger countries such as Saudi Arabia, the impact on global equities will be more significant. The conduit for this is likely to be via a higher oil price. In fact, developed markets might suffer more than many EMs as their economies are generally more sensitive to rising oil prices.

We continue to believe the investment case for EMs remains strong and investors should continue to be attracted to the stronger growth profile and robust fundamentals of the developing economies.

Valuations are attractive with the EM P/E trading about 10.9 times, which is below its long-term average, and earnings growth is expected to be around 15%-20% over the next 12 months.

Allan Conway is head of global emerging market equities at Schroders

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