Risking credit bubbles and excessive currency appreciation, emerging economies responded with a series of policy reactions. They also sought to financially "self-insure" by accumulating large international reserves.
Their response proved insufficient to fully offset potentially-reversible external influences. As such, the asset class proved technically vulnerable to the sentiment change that started on May 22 when the Federal Reserve signaled its intention to "taper" its balance sheet support for the economy and for markets—and to do so despite evidence that the U.S. was yet to approach escape velocity.
History tells us that bad technical—that is, unbalanced investor positioning and the related risk of quick and disorderly unwinds—can be particularly disruptive in the short term for a sector that, like emerging markets, has a large proportion of new and tactical investors.
Accordingly, the real question today for long-term investors has less to do with the quasi-inevitably of short-term volatility that comes from expectation of monetary policy shifts in the U.S., and more with whether these short-term bad technicals will contaminate longer-term economic fundamentals.
Not all emerging economies are alike in this respect. Many possess sufficient balance sheet strength and can use reserves to help navigate short-term instability. Some, such as Mexico, have stepped up structural reforms to improve the responsiveness of their economies. But there are economies with insufficient domestic shock absorbers and lagging policy responses—thus elevating the risk of currency depreciation and rising bond yields compromising economic stability and prospects.
So, in addition to assessing the potential duration of this phase, investors would be well advised to consider carefully at least two other issues: how the dedicated investor base will respond to the continued exit of crossover and fast money, and whether cyclical economic bumps spot will undermine the secular upside.
Our analysis points to the possibility of further technical instability in the short-term, along with price overshoots (i.e., movements beyond what is warranted by the underlying fundamentals). The resulting price action could also serve to further muddy (rather than make clear) market perceptions of the considerable differentiation that already exists.
As such, this period of instability is also likely to offer investors over time attractive entry points into higher-quality emerging market positions. Indeed, and despite the likelihood of further short-term headwinds, we are already see isolated pockets of both short- and long-term value.
Mohamed A. El-Erian is the CEO and Co-CIO of PIMCO, which oversees $2 trillion in assets including the PIMCO Total Return Fund, the largest bond fund in the world. His book, "When Markets Collide," was a New York Times and Wall Street Journal best-seller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year and was named a book of the year by The Economist and one of the best business books of all time by the Independent (U.K.).