Emerging Markets

EM exodus: More pain ahead?

As Fed rate hike looms, how prepared are EMs?

Emerging markets will continue to suffer hefty outflows as the U.S. Federal Reserve gets closer to "lift-off", the Institute of International Finance (IIF) warned on Monday, following a report that showed the asset class witnessed its biggest exodus last week in seven years.

"We think the weakest emerging markets are likely to continue to suffer from pretty large outflows both on the debt side and equity side," Jean-Charles Sambor, Asia Pacific director at the IIF, told CNBC on Monday.

Emerging markets with weaker macro fundamentals were the most vulnerable, he said, citing the Middle East and Latin America.

Investors withdrew $9.3 billion from emerging market funds in the week to June 11, according to funds tracker EPFR, the most since 2008 – the height of the global financial crisis. The bulk, or $7.1 billion, was pulled out of Chinese equity funds. Meanwhile, global emerging market funds saw $829 million of outflows and Latin America funds lost $442 million.

A combination of factors have led to heightened outflows, say analysts, including a stronger U.S. dollar, expensive valuations on emerging market assets and a rise in developed-government bond yields, which has dulled risk appetite.

Shareholders on a security trading floor in Shenyang, China.
Getty Images

While China was hit hard last week, Sambor expects Asia as a whole will be relatively shielded compared with other regions.

"Of course there are a couple of countries which we're still concerned [about]. We think Indonesia could be under quite a lot of pressure, but overall Asia is better positioned than other emerging markets, when and if, the Fed tightens," he said.

The IIF's base case is for the Fed to begin hiking interest rates in September, as many expect. The U.S. central bank's upcoming meeting on Tuesday and Wednesday will be closely watched for clues the timing of its first rate increase in 9 years.

Morgan Stanley also anticipates further pain ahead for emerging markets, particularly those located in the Middle East and Latin America.

"The recent price correction in EM equities does not make us constructive on EM equities as poor earnings, USD strength, rising DM [developed market] bond yields and expensive valuations remain our key concerns," the bank wrote in a report published on Monday.

Read MoreGartman: Emerging market flows will go straight to US

"The most affected countries in EM are primarily located in EMEA and LatAm (Turkey, Brazil, South Africa), whose currencies are vulnerable to a stronger dollar. In Asia, Indonesia would be the most negatively affected in a stronger dollar environment," the bank said.

One reason a stronger dollar poses a headwinds for emerging market corporates is because it raises the cost of servicing dollar-denominated debt in local currency terms.

Against the current backdrop, the bank favors the Japan market, which it notes is a beneficiary in a stronger dollar environment with its large export orientation.

"The recently concluded quarter was the 10th in the last 12 where MSCI EM missed consensus earnings estimates, whereas Japan beat consensus estimates for the 10th straight quarter," the bank said.

"Japan's consensus EPS continues to be revised higher, unlike in other major regions," it added.

Japanese stocks have proved far more resilient than their emerging market peers in recent weeks.

The benchmark Nikkei 225 has risen 2 percent since the end of April; during this period the MSCI Emerging Markets Index has slumped almost 9 percent.

Read MoreWhat the bond rout means for emerging markets

To be sure, not everyone is downbeat on the outlook for the asset class.

Capital Economics expects the emerging market equities to recover in the coming months based on two factors: bargain hunters and a U.S. recovery.

"We expect parts of the emerging world to benefit from the recovery in the U.S.," Capital Economics wrote in a note last week.

It forecasts the MSCI Emerging Markets Index will end the year at 1,095, up from 973 currently.