Ineffective macro policy, disappointing corporate earnings and stuttering investor demand all bode badly for emerging markets, according to ING Investment Management, which has slashed its exposure to the sector across its portfolios.
Emerging markets had a tough time in 2011 and the first half of 2012, which many fund managers looked upon as a buying opportunity.
However, ING believes the recovery in the asset class is under serious threat, and points to developing regions such as the US and Europe as far more attractive areas at current valuations.
"Macro policies in emerging market countries with the most negative current-account dynamics are not improving," the firm said.
"Equity fund flows recently turned negative for the first time in six months and investor surveys point to an overweight position in emerging market equities, which makes them vulnerable to bad news."
It also warns of a widening risk gap between the BRICs [Brazil, Russia India and China] and the US market and notes that economic data and earnings momentum statistics are both lagging that of developed markets.
ING says cyclical trends in emerging markets have struggled to keep up with signs of improvement in large developed markets such as the US, Japan and Germany.
"The momentum in industrial commodity prices is not pushing through either, a consequence of the rumoured Chinese cooling measures for the property market."
"The depreciation of the Japanese yen will also affect the competitive export position of other Asian countries such as South Korea and Taiwan," it added.
Head of multi-manager at F&C Gary Potter told FE Trustnet in a recent interview
that he was backing developed markets over emerging markets for growth.
Emerging markets have lagged developed markets in the short- and medium-term, according to FE data.
The MSCI EM index has returned 43.08 per cent over five years, compared with 49.17 per cent from MSCI AC World.
Performance of indices over 10-yrs
Source: FE Analytics
|MSCI AC WORLD
The margin of underperformance has been even greater in the short-term.
While emerging markets tend to outpace developed markets during cyclical upturns, they have underperformed during the recent market rally.
Year-to-date, the MSCI EM index is up 4.71 per cent – a full 9 percentage points less than the MSCI AC World index.
Performance of indices in 2013
Source: FE Analytics
It is not only equities that ING is cautious of; the firm has also cut its exposure to fixed interest.
"Rising developed market bond yields and low emerging market premia could put more pressure on flows from developed to emerging markets," the group said.
"This will undermine the 'search for yield'-flows going into emerging market debt markets."
Head of strategy Valentijn van Nieuwenhuijzen (pictured)
says this trend could have an even greater knock-on effect on the sustainability of debt.
"So far, the rising external financing requirements of emerging markets have been met by strong portfolio investment flows into debt instruments," he said.
"With foreign direct investment and equity flows clearly lower than the averages of the past five or 10 years, the financing of the larger emerging market current account deficits has relied primarily on debt flows."
"We are getting increasingly worried about this because the improving situation in the developed world will have a negative impact on flows from developed into emerging markets, and also because of poor macro policies in some of the key emerging market countries."
He points to India, Turkey, Indonesia and South Africa as four countries that have been particularly reliant on foreign capital, and fears their currencies could be under threat in the near future.
"Given their large macro imbalances, the currencies of these four markets remain vulnerable to a sharp correction," said van Nieuwenhuijzen.
"All four countries rely heavily on speculative inflows. India and South Africa have large structural deficits and need a political breakthrough to tighten economic policies and carry out structural reforms."
"At this point, it is difficult to see much progress in the coming years."
"Turkey looks better, because the fiscal accounts are in good shape, and the current account deficit has been narrowing. Here, it is the large energy import bill that keeps pressure on the balance of payments."
Van Nieuwenhuijzen says that of the four countries, Indonesia is the country with the best macro fundamentals.
"A low external debt ratio and both fiscal and current account deficits are still at a reasonable 3 per cent of GDP," he said.
"Foreign direct investment represents 60 per cent of the current account deficit, which makes the country less dependent on portfolio inflows than the other three."
"However, the rapid widening of the deficit and a lack of willingness to tighten policies ahead of next year’s elections make Indonesia more vulnerable than it looks at first sight."