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Investors move cautiously back into emerging markets as dollar strength fades

Investors tiptoed back into emerging market stocks last week as the recovery in the asset class looks set to continue — slowly — as the U.S. dollar's continued strength is increasingly in question.

Actively managed emerging market equity funds saw their first net inflows in 11 weeks, while passive funds saw their first inflows in four weeks, according to data from EPFR Global. Emerging market assets include stocks of companies in countries such as China, Brazil, Russia and India.

"There's been some inflow but it hasn't been that big," said Ilya Feygin, managing director and senior strategist at WallachBeth Capital.

"If you're right on the dollar you have a very good shot on being right on the general broad emerging market," he said. Feygin expects the greenback to stay under pressure and emerging markets could see better returns than developed markets this year given relative attractiveness.

Last year the benchmark iShares MSCI Emerging Markets ETF (EEM) snapped a three-year losing streak, but ended 2016 with its worst quarter in more than a year as the U.S. dollar index climbed to its highest in more than a decade. EEM is still down 2.1 percent since the election.

Now as the U.S. dollar index has pulled back and China's economy appears to have remained stable, EEM has climbed more than 4.5 percent so far this year. In contrast, the S&P 500 has only risen about 1.4 percent.

"We think overall the global economy is going to remain quite sluggish. The focus is going to be on the usual things which is the Fed, performance of the U.S. bond market and the U.S. dollar," said Geoffrey Dennis, head of global emerging market strategy at UBS Investment Bank.

"In the absence of a fundamentally stronger growth story in the emerging market, it's going to be buffeted by developments in U.S. financial markets," he said.

U.S. President-elect Donald Trump's proposed policies pose a major risk for emerging markets, analysts say, as his pro-growth and protectionist policies should support the U.S. dollar. Strength in the greenback is a negative for emerging market countries, whose large holdings of dollar-denominated debt become more expensive to pay off.

Analysts generally still expect the dollar to strengthen, although Trump's recent comments on taxes and trade have sent the dollar index to its lowest in a month.

Since investors began looking at emerging markets in the 1980s, "we've made certain assumptions about trade. That may or may not change," said David Polak, equity investment specialist at Capital Group. Will it be a "war of words or a challenge to the trading fabric?"

"That's important for Mexico and emerging markets that have grown up in a period of relatively open trade," he said.

Trump's repeated antagonism toward Mexico has repeatedly sent its currency to fresh all-time lows against the dollar. Looking across the Pacific, the president-elect has selected outspoken China critics for top positions on trade, indicating to many analysts that the U.S. will likely take a tougher stance against the Asian giant.

"We saw more positivity last year in part because of more sanguine Asia or China data that was coming out," said Adrian Helfert, head of global fixed income at Amundi Smith Breeden. "Now that people are reviewing their assumptions, now that Donald Trump is going to be our president let's see how realistic all that rhetoric is going to be."

The world's second-largest economy plays a major role in sentiment around emerging markets. Chinese stocks also make up more than a quarter of MSCI's emerging markets index.

"In 2017, we're still looking at a picture of general economic recovery across the emerging markets world. … On the negative side, we're still expecting growth in China to slow down," said Louis Lau, director of the investments group and a member of the emerging markets investment committee at Brandes Investment Partners.

"The impact of China in '16 and '17 and maybe the next few years is going to cast a shade on emerging markets," Lau said. He has less than half benchmark allocation to China.

China's economic growth and politics are particularly in focus this year as Chinese President Xi Jinping is expected to consolidate his power at the Communist Party congress in the fall.

But at least for the next 12 months, the trade discussion should bring volatility but not fundamental reasons for a decline in emerging market assets, said Atilla Yesilada, local partner in Istanbul for emerging markets investment consulting firm GlobalSource Partners.

"To me 2017 is a transition year. … This year there will be a lot of smoke but no fire," he said.