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Emerging Markets Being Left Out of Global Rally

Ivan Bliznetsov | E+ | Getty Images

Despite a revival in risk appetite — which has sent global stocks up 6 percent since the start of the year — emerging markets appear to be losing out as investors pile into larger, developed markets on expectations of improving economic conditions.

The MSCI Emerging Markets Index has slipped 1.1 percent since the start of the year, weighed down by recent losses in Chinese and Indian equities — a stark contrast from developed markets, in particular the U.S. and Japan, which are roaring ahead, up 10 percent and 18 percent, respectively, over the same period.

Market participants like Mohammed Apabhai, head of Asia trading at Citigroup Global Markets, warn emerging markets will likely continue to lag in the coming months, adding that a large force behind the divergent market performances is differing liquidity conditions.

"If you rank markets according to their provision of liquidity - in markets like Japan, the U.S. and even Australia — you are seeing a net addition of liquidity by central banks - whether it's through the promise of lower rates, QE [quantitative easing] or promise of more QE," Apabhai said, noting that there is a 70 percent correlation between liquidity and stock market performance.

In contrast, with high inflation risks in economies such as China, India, and Brazil, central banks are limited in the support they can provide through monetary stimulus.

(Read More: China Central Bank Warns on Inflation, Pledges Reform)

China's central bank governor, Zhou Xiaochuan, on Wednesday said his top priority is managing price gains in the world's second largest economy. The country's consumer price index jumped 3.2 percent in February, its highest level in 10 months.

Strong inflationary pressures equates to the possibility of higher interest rates, which is a worry for investors, Apabhai said, adding that he is most cautious on Chinese and Indian equities at the moment. The benchmark Shanghai Composite and Bombay Sensex have vastly underperformed global markets — both down 0.3 percent year-to-date.

In addition to worries over inflation, Mark Matthews, head of research, Asia at Julius Baer, said doubts over the growth outlook for large developing economies are becoming a concern. India's gross domestic product growth, for example, fell sharply to 4.5 percent in the fourth quarter of 2012, the slowest pace since 2009.

"The largest markets, China, India, Russia and Brazil, just aren't very appealing right now. There are some question marks over their growth rate going forward," he said.

(Read More: Crumbling BRICs: You're Better Off Elsewhere)

He, however, added that while economic growth rates in these emerging markets are far above developed markets, this is not the case in earnings per share (EPS) terms.

Despite an economy that is barely growing, Japanese equities are expected to have the strongest EPS growth in Asia this year at 40 percent helped by improving confidence, fiscal spending and yen weakness, compared with growth of 13 percent for both India and China, according to Matthews.

"There is no shame in that number, it's the Japanese one that is abnormally high," he added.

Don't Give Up, Yet

Catherine Yeung, investment director at Fidelity Worldwide Investment, a global asset management firm, however, is not giving up on emerging markets just yet.

Yeung said investors who are looking to get back into the stock market are still nervous, and are therefore opting for U.S. stocks, which are a so-called safe-haven equity asset class. As investor confidence grows, she believes flows will shift from the West to the East.

Jan Dehn, co-head of research at Ashmore, an investment firm specializing in emerging markets equities, said the trigger for investors to allocate more funds towards emerging markets will be a correction in U.S. equities, which could come in the next quarter.

"Emerging market assets are far safer than developed market assets, and you will get a good entry point once the irrational exuberance that is creeping into some of the developed markets comes out," he said.

(Read More: Emerging Markets: The Big Story of 2013?)

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