Unless the Federal Reserve raises rates next week, a prolonged panic should not ensue

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Everyone has days when it feels like the smartest strategy would have been to hit the snooze button. Monday, when emerging markets, among others, virtually fell out of bed would seem to be one of those. But hold those duvet day dreams: this EM sell-off in particular was overdue. Unless the Federal Reserve raises rates next week, giving form to the fear behind the market move, a prolonged panic should not ensue.

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The Short View

Emerging market equities have just enjoyed their strongest and longest outperformance in six years. Compared with developed world markets, they have done better so far this year by 12 per cent in total return dollars, according to BNP Paribas Investment Partners. The case for backing the sector is based on emerging markets’ better growth outlook compared with the developed world. Even Russia and Brazil, which have weighed on sentiment this year, are expected to return to growth in 2017. As to the Fed, emerging markets’ fortunes do depend on it not turning ultra-hawkish. But for all its talk, the Fed has shown little sign of being prepared to shock markets.

Valuations in the emerging universe had certainly run up and, even more pertinently for Monday’s slide, emerging equities had seen 10 straight weeks of hefty inflows up to last Friday, according to Morgan Stanley. That was their longest cumulative series of inflows in more than two years. If not an absolute short-term sell signal, that at least suggested taking greater care.

There is, however, another factor in emerging markets’ favour: the lack of an alternative. Developed markets are close to their most expensive levels in 200-plus years, according to Deutsche Bank’s annual long-term asset study. This column normally takes a shorter view, however, and on that basis, investors will want to take care in the run-up to the Fed’s meeting.

Since emerging markets swung back into favour following the post-Brexit turmoil, the trade has indeed often felt more of a case of “nothing else on” than a conviction “risk on” trade — and so it remains. That doesn’t, however, mean it is wrong, just that it is crowded — although at least at better valuations than it was before Monday, and probably at better levels still as the Fed’s decision nears.

jennifer.hughes@ft.com

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