The recent Emerging Market rally is built off a combination of fundamental and technical factors. The most powerful catalyst was the oversold conditions that technically set up Emerging Markets to outperform the developed equity landscape for the last month.
Fund flows out of emerging markets hit record levels of negative sentiment with 22 straight weeks of outflows before turning 10 days ago. In all my years of dealing with EM cycles of crisis and negativity, this was the longest most sustained period of negativity built less off of panic than disinterest in the asset class. Clearly some panic emerged in February only because the US needed to find a culprit for its selloff. ETF flows underscored that mood with almost 9% of total AUM outflow from the major Emerging Markets ETFs like iShares MSCI Emerging Markets Index ETF (EEM, quote) and Vanguard FTSE Emerging Markets ETF (VWO, quote).
China (FXI, quote) has been ironically a place to see the sentiment turn. While clearly to me nothing has changed in terms of macro China risks (corporate debt crisis, lower industrial growth trends and structural economic issues like rising labor costs and input pricing) investor sentiment to China got to panic levels creating part of the capitulation moment for markets.
Emerging Markets needs China for any sustained rally. While I do not believe China will present near term growth or structural reform to fundamentally change the near-term trajectory of their economy, I do believe China can continue a re-rating off extreme pessimism. I'll save more drawn out comments about media and specific talking head fear mongering on China for another time but say simply there are a lot of inaccurate and irresponsible comments on China in the market. A lack of China implosion commentary and data points that will stoke this fear can do a lot for this rally as opposed to some real economic change.
The spread between the Emerging Markets MSCI index and the SPX is one of the great oversold trades and markets. We version to the mean must take place and certainly will be built off some fundamental drivers.
The prospect of political change is out there as a rally point for India (EPI, quote), Brazil (EWZ, quote), Latin America, and large parts of South East Asia. This will continue even though I don't expect tangible near-term change.
I believe G3 growth is accelerating in choppy but real steps. Emerging Markets will thrive in this environment. I don't think emerging markets will be a straight line higher but would be adding allocations. Remember however the most money is made in Emerging markets when things go from terrible to bad, not when things go from good to great.