At the end of Q1 2017 it is clear that emerging markets continue to outperform developed markets by a considerable margin. 
Emerging market currencies are up more than 3 per cent versus the dollar so far this year compared to an outperformance of 50bps last year. Local currency bonds have returned 6.5 per cent in dollar terms year-to-date compared to just 67bps for similar duration US government bonds.
Emerging market stocks are up nearly 11.50 per cent compared to 6 per cent for the S&P 500 and high yield bonds in emerging markets are up close to 4 per cent compared to 2.6 per cent for US high yield bonds.
Performance of MSCI EM vs MSCI World YTD
Source: FE Analytics
Of course, emerging market fixed income also outperformed developed markets fixed income last year, but the outperformance is accelerating this year compared to last year. What is behind this profound change from the 2010-2015 period during which emerging market assets struggled, particularly in local markets?
Valuations in emerging markets have become very attractively priced
There are two basic reasons for the improving performance of emerging market assets. The first reason is the most natural of all, namely that valuations in emerging markets have become very attractively priced. In this respect, emerging markets are of course like all other markets, except that due to deeply held prejudices about the asset class, emerging market assets often have to move far deeper into value territory before investors pay attention. On the other hand, when sentiment then changes the upside is that much higher with very handsome rewards to those who bought when everyone else sold.
Emerging markets is clearly attractive in its own right at current valuations and fundamentals. Yields are very high both in real and nominal terms.
At this particular time the high yields represent value, because growth is improving across emerging market countries, led by improving external balances while inflation has declined significantly in recent years and remains at multi-year lows. In addition, emerging market currencies are trading at close to 13-year lows in real terms.
Finally, technicals are strong, because foreign investors in particular have been reducing exposure to emerging markets for several years and most have so far missed the turning point in the market, which took place more than a year ago.
The holding structure of local bonds is now heavily skewed towards locals and this bodes well for economic growth in emerging market countries as flows return.
Local currency-denominated instruments – both stocks and bonds – were particularly out of favour during the widespread selling of emerging market assets in the last few years, which means these assets are now mainly held by local institutions such as banks, pension funds and insurance companies.
There are very few local currency-denominated assets left in foreign hands. Hence, as foreign investors come back to local markets they have to turn to local players for securities instead of buying them from investment banks in New York or London.
The result is that capital flows back into emerging market countries, which then begins to reverse the financial tightening of recent years which contributed so much to the slowdown in growth in emerging markets (though without creating widespread defaults or balance of payments crises due to strong, deeper fundamentals).
A benign cycle is therefore now underway, whereby capital inflows help to unleash faster growth rates. This is only possible, because emerging market countries are severely capital constrained.
For example, emerging market countries account for nearly 60 per cent of global GDP, but less than 20 per cent of global fixed income. By contrast, developed economies account for just 40 per cent of global GDP, but more than 80 per cent of global fixed income.
No wonder then that capital inflow to emerging markets will revamp growth. Nor is it a mystery why bonds and stocks in developed economies offer so little value, since too much money is chasing these assets.
The global backdrop has changed
The second reason why emerging markets are outperforming is that the global backdrop has changed. It is not a great exaggeration to say that most of the recovery in developed economies since their crisis in 2008/2009 has been driven by monetary stimulus, conventional and otherwise.
Very, very few developed economies indeed have undertaken any meaningful reforms or even seriously attempted to deleverage their economies. Indeed, most governments have dramatically increased their debt burdens.
The problem they face now is that inflation is rising, especially in the US. This means that central banks have to tighten policy, however reluctantly. The resulting tightening of financial conditions removes the fuel which has propelled developed markets in recent years.
Performance of US Consumer Price-All Urban Consumers over 3yrs
Source: FE Analytics
While most developed economies ought to have become self-propelling by now in terms of growth the sad fact remains that their failure to deal with the underlying debt and productivity issues has rendered their growth rates extremely tepid despite enormous financial tailwinds due to zero interest rate policies, QE and capital inflows from all over the rest of the world.
Governments are therefore turning back to fiscal stimulus, but this will only increase debt burdens further and thus undermine long-term trend growth rates even more.
The return to fiscal policy also has very undesirable consequences for bond markets. Fiscal means net supply of bonds, where QE was net demand for bonds. Combined with the roll-back of QE and the return of inflation, the increase in supply of bonds through fiscal stimulus now means a triple whammy of head winds for developed market bonds.
Investors are rightly switching from bonds into stocks, because although stocks are also overvalued at least they rise with inflation rather than lose money as prices rise.
But to the extent that investors also want to have some fixed income in their portfolios and not just stocks they are also now forced to reverse the QE fixed income trades of recent years by putting money back into emerging markets bonds. Of course, this is not a bad trade for reasons given above, provided, of course, investors can get over the widely-held view that emerging markets are somehow too risky.
This switch from developed market bonds into both stocks and emerging market fixed income has already restored the positive correlation, which has traditionally existed between developed markets stocks and emerging markets local bond market performance.
Correlation was temporarily turned on its head by the temporary fear of deflation and massive QE purchases, but as these conditions are reversed, so are emerging markets’ fortunes.
Needless to say, positive correlations with US stocks render emerging markets vulnerable to US equity market corrections, but with few other easing options at its disposal the US government would probably welcome a lower dollar if the stocks markets were to correct meaningfully lower.
This should support emerging market currencies and thus make local bonds extra attractive, even if US stocks correct lower (as they should do in the not so distant future).
Jan Dehn is head of research at Ashmore. The views expressed above are his own and should not be taken as investment advice.