Could Emerging Markets Finally Bounce Back?

The S&P 500 (SNPINDEX: ^GSPC  ) reached new all-time highs last week, with excitement about the prospects of extended periods of Federal Reserve assistance helping to lift the stock market higher. But arguably more remarkable than the big gains for the S&P was the fact that emerging markets finally started to show some signs of life with stock market gains of their own.

The sad state of emerging markets
So far in 2013, emerging-market stocks have been doing terribly. Looking at the most popular exchange-traded funds tracking emerging markets, both iShares MSCI Emerging Markets (NYSEMKT: EEM  ) and Vanguard FTSE Emerging Markets (NYSEMKT: VWO  ) have suffered losses this year of more than 10%, compared to double-digit percentage advances for U.S. benchmarks.

The challenges that emerging markets have faced are numerous:

For more than a decade, investors have gotten used to the idea that the most prosperous emerging-market economies can grow at double-digit percentage rates annually for extended periods of time. Yet as these economies grow, they inevitably face slowing growth, and investors are only now starting to understand that being disappointed about things like Chinese growth falling to the 6% to 8% range is increasingly unrealistic. Many emerging markets, such as Brazil and Russia, are wealthy in natural resources. The plunge in prices for gold and silver as well as more basic commodities like coal and iron ore has really put a damper on economic growth in those countries, as they've no longer been able to rely on exporting materials to fast-growing areas like China and India. Brazil has even had to put up with civil unrest and rioting as citizens grow anxious about inflationary pressures and a slowing economy. U.S. investors have taken to emerging markets as a haven for avoiding the dangers and volatility of the U.S. stock market. But now that U.S. stocks are doing so much better than the rest of the world, investors are pulling their money closer to home, exiting emerging-market stocks and exacerbating the magnitude of losses.

Emerging-market woes aren't limited to stocks, either. Bonds from emerging-market countries have also suffered significant losses, as investors had taken advantage of Fed-provided liquidity to seek higher interest rates abroad. As Treasury rates have climbed, however, their relative creditworthiness has made overseas bonds look less attractive, sending prices sharply lower in many cases.

Is emerging-market risk back on?
Emerging markets certainly showed signs of strength in Thursday's big market rally, with emerging market ETFs climbing between 4% and 5%. But the troubling thing about how tenuous that rally seems to be is that the ETFs weren't able to follow through with gains on Friday, even though U.S. stocks posted modest advances.

Until emerging markets are able to convince battle-scarred investors that they can put together a broad-based long-term recovery, investors are likely to be dubious about their prospects. Moreover, the U.S. market has been so easy to make money in that there doesn't seem to be much reason to expand your horizons to seek out profits. As long as that trend lasts, emerging markets could continue to underperform badly compared to domestic stocks.

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