LONDON, July 4 (Reuters) - Risky emerging stock markets have had a storming rally in the past month on a more upbeat view of the world’s prospects, though their fate remains inextricably linked to that of the euro zone.
The growth outlook for China - the export destination for emerging commodity producers like Brazil and Russia - and the impact on the oil price of tensions over Iran are also major risks as emerging and developed economies become more interdependent.
Emerging stocks have leapt since confidence began to grow in early June that Greek voters would reject more radical parties at their mid-June elections, staving off the unprecedented threat of an exit from the euro zone and encouraging investors to seek higher returns from riskier trades.
The markets got another shot in the arm late last week, when euro zone leaders surprised investors with the extent of the progress at their summit in tackling the bloc’s protracted debt crisis.
“Emerging markets are very much hostage to developments in Europe,” said Gabriel Sterne, economist at brokerage Exotix.
“A lot of this is not based on country specifics, but on the euro crisis.”
Because emerging markets tend to be less liquid, their prices move more sharply than developed markets when investors decide to buy or sell. Such investment decisions often depend largely on how easy - and therefore cheap - it is to raise money in the financial markets.
The higher yields which emerging debt markets offer become particularly attractive when low interest rates in the developed world encourage investment.
Some emerging economies, notably Brazil, have complained they are at risk of inflation and boom/bust cycles as investors export the cheap cash that major central banks have been pumping out to try to kickstart developed economies.
The benchmark emerging equities index has jumped in the past month, hitting its highest in six weeks, making gains of six percent just since last Thursday.
Developed markets have also rallied in the past few days, but by a smaller four percent, though European banking stocks, which often have subsidiaries in emerging markets, also rose by nearly six percent.
Some of the strongest performers have been markets which suffered in 2011, such as Kenya, the best-performing frontier market, or lesser-developed emerging market, this year, and Egypt, the best-performing emerging market.
Emerging markets largely outperformed developed markets between 2003 and 2010 but since the beginning of last year they have taken the brunt of the world’s economic woes.
While investors have focused heavily on the four largest BRIC economies - Brazil, Russia, India and China - these have been some of the worst performers this year, with the key being lowered expectations for growth in China.
Commodity exporter Brazil has slashed growth forecasts and India has a record current account deficit.
Russia has also suffered from the falling oil price in recent weeks, but its stock market has jumped a massive 10 percent in the past few days, due to its strong correlation to the price of the country’s oil exports.
Concern over oil-producing Iran’s reaction to European Union sanctions, which came into force this week, has helped to push oil above $100 a barrel.
This kind of worry could even outweigh the dampening effect of weaker Chinese growth on oil exporters.
“The geopolitical risk premium that has been washed out of the oil price is set to return over the coming year, potentially leading to record prices in 2013,” said Emad Mostaque, Middle East and North Africa strategist at Religare Capital Markets, in a client note, adding that “we have identified risks in Algeria, Sudan, Nigeria, Iran, Iraq and key GCC (Gulf Cooperation Council) nations”.
The euro zone crisis has by no means gone away, with 12 out of 28 fund managers polled by Reuters last month still expecting Greece to leave the euro zone.
Emerging Europe, in particular, is closely linked by trade and banking ties to the single currency bloc.
But relatively strong individual companies in emerging markets such as Turkey or Russia could attract investors who are tired of euro zone banking and corporate risks.
Some countries that were once labelled ‘low risk’ on the basis of their euro zone membership are now on downward credit rating trajectories that make them look a poor choice compared with emerging debt market alternatives.
“We have seen a structural shift in asset allocation from mature bond markets into emerging bond markets,” said Thanasis Petronikolos, head of emerging market debt at Barings Asset Management.
“You can get much higher returns from emerging markets.”
If markets are starting to level out, indiscriminate buying or selling of the emerging market asset class could also be replaced by a more measured approach, weighing up the investment pros and cons of individual emerging economies.
“In the next couple of months, emerging markets will hopefully get in that window where enough funds will think of these markets in their own right ... looking at country fundamentals,” said Sterne.