I am starting to get a lot of questions from investors regarding the sustainability of this rally in Emerging Markets and what can be the drivers for the next leg(s) higher.  emerging market funds

As developed markets start hiccuping can Emerging Markets continue to outperform?  Let's address: Clearly we are starting any rally in Emerging Markets from very oversold conditions. Any measure of fund flows of fund manager sentiment taken over the last 5 months shows building levels of discontent and outright avoidance of the asset class.

Having said that, despite the record outflows, we are not sure we have seen a capitulation level yet in terms of investor behavior. I base this on comparisons to other periods in Emerging Markets history which showed some tell-tale signs of a turn.  This is not the "all in" moment yet, but I do think we are close. 

What still concerns me?  I believe China has the ability to take us lower with headlines that will not be pretty for the next six months.  China can paper over their problems and is moving slowly to reform their economy, but until we see real deleveraging, China is the greatest risk followed by CB policy failure in US, ECB and Japan.

What is positive on fundamentals is that we are starting to see positive macro surprises in Emerging Markets relative to Domestic Markets.  We are getting stronger PMI readings, better current account data and overall solid numbers while the currencies have made many of the Emerging Market economies more competitive and real rates have started to climb. This is all built on a base of low unemployment and inflation levels that Emerging Markets are very happy with. 

From a valuation perspective Emerging Markets are NOT that cheap.  We are not at historical levels of value. Stocks are very cheap in some places (Russia RSX, quote), reasonably cheap in others (Brazil EWZ, quote, S. Korea EWY, quote), but not cheap in others (Mexico EWW, quote, India EPI, quote).  We like the P/B readings but see that earnings need to recover to get P/E multiples to outright buy levels. 

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