Why Emerging Markets Are Still on Shaky Ground

A trader looks at a stocks monitor at the Philippine Stock Exchange in Manila. The market, together with stocks in other emerging markets, were hit hard last week.
Jay Director | AFP | Getty Images
A trader looks at a stocks monitor at the Philippine Stock Exchange in Manila. The market, together with stocks in other emerging markets, were hit hard last week.

Emerging markets remain vulnerable after the ugly sell-off last week, as concerns about an unwinding of the U.S. Federal Reserve's monetary stimulus program keep investors on edge, analysts say.

The MSCI Emerging Markets Index, the benchmark for emerging market stocks, tumbled to its lowest level since September last week, while currencies such as the South African rand and Indonesia rupiah took a pounding.

And, in a sign of heightened concern about a sharp outflow of funds from emerging markets, Brazil, Indonesia and India have all stepped up measures to either stem the outflows or shore up battered currencies.

(Read More: Asia's Fight to Stem Fund Outflows Just Starting)

"We think fund outflows have further to run, maybe for another month or so before markets stabilize," Will Oswald, global head of fixed income, currencies and commodities at Standard Chartered Bank, told CNBC Asia's "Squawk Box" on Monday.

While stocks globally have been hurt by the prospect of an unwinding of the U.S. monetary stimulus that has provided a significant boost to risk assets, emerging markets have been especially hit hard.

The MSCI Emerging Markets Index is down almost 10 percent so far this year, while the S&P 500, a broad measure of U.S. equities, is up more than 16 percent.

"Since May 21, when U.S. Federal Reserve Chairman Ben Bernanke's comments to the Joint Economic Committee triggered a global sell-off, markets in Asia have corrected in a manner akin to a crisis," analysts at Deutsche Bank said in a note, referring to comments Bernanke made regarding a possible end to the Fed's quantitative easing program.

(Read More: Why the Fed Will Try to Calm Market Nerves)

"While one can question if this sell-off makes sense, the fact of the matter is the pace and magnitude of asset price decline has reached the point of risking a negative feedback loop, where a host of negative real economic developments can take place in response to the market slide," they added.

The Fed starts a two-day policy meeting on Tuesday and its policy statement could determine whether emerging markets win some kind of reprieve this week.

(Read More: Heeer's Bernanke: Will the Fed Finally Get Specific?)

"We think that when the tapering starts, it is possible that the biggest casualties will be emerging markets, because they are flow markets, so they have enjoyed the money on holiday from the U.S.," said Vasu Menon, vice president for group wealth management at OCBC Bank in Singapore.

"So when the Fed back tracks, the money is going to pull back and risky assets are going to see the biggest weakness and the biggest under performance relative to other markets," he told CNBC Asia's "Cash Flow."

Don't Fret

Analysts say there are some reasons why the heavy selling in emerging market assets is unlikely to be prolonged, such as long-term interest in these assets from global central banks and big institutions.

"We do think that the majority of money into EM [emerging markets] is sticky money, from central banks, large pension funds and it is there to stay," Oswald told CNBC.

"We've seen that money coming in from 15 percent of bond markets in EM owned by foreign investors [has risen] to 37 percent, so there has been a big increase and we think that's here to stay," he added.

(Read More: Behind the Massive Bet Against the Emerging Markets)

Jonathan Garner, chief Asian equity strategist at Morgan Stanley, said in a note that he thought emerging market stocks were now reaching levels where they have troughed in the past.

"Our suggestion is that recent market declines are overdone," he said.

By CNBC.Com's Dhara Ranasinghe, Follow her on Twitter: @DharaCNBC