Capital inflows into the emerging markets have noticeably notched up over the summer. 
According to Goldman Sachs, inflows into actively managed GEM equity funds in recent weeks represent the largest streak since February 2013.
Emerging Market debt has also become increasingly popular, as investors have been prepared to take more risk in the desperate search for yield at a time when around a third of government bonds across the globe are now on negative yields.
Performance of sector and indices in 2016
Source: FE Analytics
Despite this apparent cheeriness, we would still urge a caution towards emerging markets, for a variety of reasons.
A major risk for investors contemplating piling into EM is that the dollar renews a strengthening trend
A strong dollar pushes up costs for emerging market countries and businesses that have borrowed heavily in dollar-denominated debt as many have during the years of ultra-accommodative Fed policy and a rise in the dollar also has the capacity to trigger capital outflows from these markets as funds are repatriated to dollar assets.
So, a halt to dollar strengthening this year as the Fed has paused on further rate hikes has eased pressure on emerging markets.
Relative performance of currency over 3yrs
Source: FE Analytics
But market expectations are now pointing to a probability of a further US rate rise before year end.
In recent days there has been considerable turbulence on the markets as fears of a Fed rate rise gathered pace last Friday, which were then subsequently quelled on Monday by dovish comments from Fed official Lael Brainard.
While her statements have diminished fears of a rate rise being announced in September, investors should take note of how skittish markets will be to a rate rise. When the US tightens policy further, this could lead to a sharp reversal in the more buoyant performance we’ve seen from emerging markets this year.
China remains a major concern
While Chinese economic data for August released today for factory output and retail sales has beaten market expectations and on the surface suggests a stabilisation in the Chinese economy, investors should be very sceptical about how durable this is.
Private investment is weak and China is becoming increasingly reliant on government spending to drive economic activity, much of which is of questionable efficiency land will lead to further overcapacity.
As policy support from the last round of stimulus fades, more fundamental cracks in the Chinese economic model may well return to the fore.
Chief amongst these concerns is the rapid expansion of credit in China to finance property and infrastructure investment, much of which has been provided through an opaque shadow banking system through the issuance of so-called ‘wealth management products’.
In fact new credit is continuing to be created while non-performing loans are on the rise. While official policy is to rebalance China away from exporters and infrastructure investment towards developing the Chinese consumer, progress has been slow.
There are some clear and worrying similarities between where China stands today and that of Japan in the early nineties: its demographic profile is set to deteriorate, equity valuations are high and its private sector debt build-up has been rapid.
China represents a key systemic risk to global markets, more so than Brexit ever did in our view.
Market euphoria over political reform is overdone
One of the hottest spots in the emerging market universe this year has been Latin America, which is dominated by Brazil.
Performance of indices in 2016
Source: FE Analytics
While we see the ditching of Dilma Rousseff as President of Brazil as a positive step given her disastrous mismanagement of the economy, capital markets have an unfortunate habit of being too bullish in their expectations around the pace of reforms that stem from political change.
We have seen this in Japan, with the initial excitement about “Abenomics” has now faded, and to a lesser degree with the unrealistic level of expectations initially placed on Narendra Modi in India.
In those two countries, the respective premiers came to office with strong popular mandates. Rousseff’s replacement in Brazil, Michel Temer, has no such mandate and he is facing stiff resistance from Rousseff’s supporters.
The task of turning around this basket case economy will be a formidable one, with no quick fixes nor assurance of success.
Another tail risk for EM could be a Trump victory in November
In the aftermath of the Democratic convention Trump’s polling numbers were trailing badly as he was dogged by critics from within the Republican camp.
But he has been closing the gap and the impression that Hillary Clinton sought to hide health problems could impact the campaign. In the US, TV debates are often seen as key moments in Presidential campaigns and the first of these is set to happen later this month. It is too early to dismiss the prospect for a Trump victory.
Why would this be bad for emerging markets?
Firstly because Trump’s economic platform is to implement very aggressive tariffs on countries like China and Mexico, to protect American jobs. Secondly Trump advocates massive fiscal stimulus at home through deep tax cuts and infrastructure spending.
These latter measures would likely see new Treasury bond issuance, encouraging capital to return to the US.
Jason Hollands is managing director of Tilney Bestinvest. All the views expressed above are his own and shouldn’t be taken as investment advice.