The one early success story of the reflation trade has been emerging markets. Investors have been piling in since the start of the year, drawn by stronger growth prospects and lower valuations. Can this enthusiasm last?

The Financial Times reports that the top 30 major developing countries have attracted $17bn in inflows for the first three weeks of January alone. This flood of capital has helped push emerging market (EM) funds up the sector league tables. Over the past three months, the average EM fund has risen 16.4%, almost double that of the North American sector.

EM fund managers have been beating the drum for the sector for some time, noting that the economic devastation of Covid-19 had been lighter, earnings and dividends had proved more resilient and developing countries were likely to emerge from the pandemic with less debt and faster growth. This was on top of all the previous trends that were still in place: infrastructure build, demographics, technology change and so on.

The problem is that this message hadn’t really cut through. It took a ‘risk on’ mood in markets for investment to return to EM. Even then, much of it has been directed towards China, buoying China’s dominance of the major EM indices – it is now 40% of the MSCI Emerging Markets index, for example.

This suggests that investors are not quite as ‘risk on’ as might initially appear and also that EMs can’t quite shake off their reputation as ‘risk-on’, cyclical investments. Managers specialising in smaller markets bemoan the fact that Alibaba and Tencent have a higher combined market capitalisation than the entire Mexican market. Latin America, Eastern Europe and smaller Asian markets remain overlooked.

This is a real shame because many smaller emerging markets offer exactly the qualities that investors need after the shocks of 2020. They offer self-sustaining, organic growth, geared into long-term trends. Companies deliver a growing income and saw far fewer dividend cuts last year. Valuations, outside China, look far more compelling than elsewhere across the globe.

EMs still appear to be a good choice for those betting on reflation, particularly the commodity exporters. Their recent popularity could broaden out as the recovery takes hold. Ultimately, we are only in the foothills of this recovery.

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This article was sourced from Adviser-Hub.co.uk.