In recent weeks, global financial markets have been characterised by volatility and weakness in emerging markets (EM). Developing countries’ currencies, debt and equity markets are having the worst start in recent years, with investors withdrawing from specialised funds at a record pace.

The reduction in the US Federal Reserve’s bond buying programme, with its associated impact on overall liquidity in global financial markets, is one of the major drivers of the sell-off in EM assets. In May 2013, the Fed first announced that it was planning to slow quantitative easing by tapering its bond purchases. This triggered outflows of capital from the EM space. Investors began rebalancing their portfolios after years in which EM (or developing) markets were one of the main beneficiaries of ultra-accommodative monetary policies in the developed world.

Beyond the Fed’s monetary policy, investor concern has also been growing due to the re-emergence of structural weaknesses in several emerging economies. A number of countries (such as Brazil, Turkey, South Africa, and Argentina) are facing challenges that include, to varying degrees, slowing growth, current account deficits, decreasing foreign exchange reserves and rising inflation. Additionally, political uncertainty is amplifying the idiosyncratic risk associated with some of the countries.

The apparent slowdown in China’s economy is another worry for investors, as reflected in the prompt reaction of EM assets whenever relatively negative economic data is released.

In this respect, it should be kept in mind that China has increasingly become a major economic partner for a big part of the developing world. This is particularly the case for countries that export commodities.

Going forward, differentiation between EM countries is expected to become more important

The above concerns have resulted in a sell-off of EM across asset classes – including currencies, credit, and equities. Over recent months most EM currencies have been weakening against the US dollar, reflecting the ongoing rebalancing of portfolios referred to above. In the longer term, currency devaluation may help in correcting a current account deficit by boosting exports. However, the abrupt reversal of capital inflows in countries with external financing requirements aggravates their situation, raising foreign currency denominated debt burdens, increasing inflation, and often interfering with sound economic management. This deteriorating economic outlook in turn increases the likelihood of further rounds of selling, for example of EM debt, by foreign investors.

The pivotal role of currency movements in the current turmoil is reflected in the fact that local currency emerging market debt has generally underperformed “hard” currency (typically denominated in USD or euro) emerging market debt. Additionally, most of the losses in local currency emerging market bonds seem to have been due to currency depreciation rather than negative returns from the bonds themselves.

Going forward, differentiation between EM countries is expected to become more important. Following the period of currency adjustment, the situation may stabilise for countries that have less structural weaknesses than others. Local currency emerging market debt will remain more vulnerable than hard currency debt, especially for countries with large current account deficits. However, investors should also keep in mind that hard currency bonds are exposed to movements in the US yield curve.

More generally, developments in EM could still be the catalyst for volatility in credit and other risk assets. As the extraordinary liquidity continues to be withdrawn from the global monetary system, there is scope for further repatriation of flows away from the EM space. This adjustment could lead to higher sensitivity to bad news and a general shift towards lower risk assets.

A selection of currency and bond performances since early May 2013.

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This article is the objective and independent opinion of the author. The information contained in the article is based on public information.

Curmi and Partners Ltd is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Karl Falzon is a credit analyst at Curmi and Partners Ltd.