Diversification is key for investors when markets are volatile

THE past three to four years have been challenging for investors in emerging markets, and those looking for a turn in the region's fortunes this year will have to be patient. The consensus opinion among strategists remains to be overweight in developed markets, in particular the US, even if the US bull market may well be past its prime. Returns from emerging markets have been negative, a far cry from the past decade when they were in double digits. The investment case for emerging markets had been built on a happy confluence of factors - relatively strong economic growth compared to mature markets; large populations; a growing middle class potentially signalling a strong domestic consumption base; and a robust outlook for commodity producers. Today, some of those factors remain intact but the macro environment has shifted - and not necessarily in emerging markets' favour.

One of those changes has been the economic resurgence of the US, which is leading global growth. The accompanying strength of the US dollar has taken the shine off emerging assets. This has shown up starkly in portfolio flows. Data from the Institute of International Finance (IIF) shows a sharp outflow in December, as the plunge in oil prices raised concerns over Russia and heightened risk aversion. A second factor is the poor outlook for commodities, in particular oil. This has mixed implications for emerging markets. Oil importers which include many Asian countries and India are expected to benefit. The opposite is so for resources producers, such as Malaysia and Russia. A third factor is while monetary policy in developed and emerging economies will be mixed, actions of the US Federal Reserve are still widely expected to wield a knock-on effect on capital flows. IIF's model finds that a tighter monetary policy has a far greater effect on portfolio flows in emerging markets than a shift towards an easier policy. Finally, with the backdrop of anaemic global growth, exports are expected to be subdued at best.

The silver lining is that emerging market valuations are attractive relative to developed markets, trading at just about 10 times earnings, the cheapest in nearly a decade. Emerging countries' growth still outstrips that of developed markets, albeit by a narrower margin of around two percentage points. To be sure, investors will need an exposure to emerging markets for diversification reasons. The key is to be selective given the divergence in economic outlook and monetary policy. At the moment, strategists are most optimistic about India, for instance, where growth in 2015 is pegged at 6 per cent. China is also favoured.