Emerging market stocks and bonds have gone from being some of the most beloved investments of recent years to the most distrusted.
Investors are pulling billions out of them as they wonder if developing markets from Asia to Latin America could set off another global crisis. The concerns have brought back memories of past crises in emerging markets such as the Asian currency crisis or the Russian debt debacle of the late 1990s. The U.S. ended up bailing out a presumably masterful hedge fund, Long-Term Capital Management, which had made a massive bet on Russian bonds.
Analysts contend emerging markets are nowhere near igniting such a disaster now, but the markets are known to be subject to contagion. If investors lose confidence in some, they get worried about the entire group. That can spark a chain reaction, with investors snubbing them all and leaving them starved for the money needed to pay debts and keep growing.
Investors instead are opting to park their dollars in the U.S. and Europe.
Emerging market stock and bond prices have dropped so sharply that DoubleLine bond funds Chief Investment Officer Jeffrey Gundlach said last week he doesn't understand why investors aren't doing what they are supposed to do: Buy low. Yet Gundlach answered his own question. Low prices are not attracting investors because of "fear and loathing," he said.
Still, emerging markets have not fallen nearly as precipitously as they have in the past, and that has led many an analyst to suggest sitting this one out a while longer because bad could turn to worse.
Citigroup's global asset allocation team said in a recent note to clients: "We recognize the absolute valuation case," but we "choose to continue to pay up for relatively expensive U.S. stocks and Europe."
The iShares JPMorgan Emerging Market Bond exchange traded fund has declined 11 percent this year; 6.6 percent during the past three months. The iShares MSCI Emerging Market stock exchange traded fund has dropped 13 percent this year and 6.5 percent in the past few months.
By comparison, the U.S. stocks of the Standard & Poor's 500 have climbed about 15 percent.
The problems with emerging markets became evident in the spring as the Federal Reserve started to hint that it would begin a process of buying fewer U.S. Treasury bonds and mortgages. The Fed's bond-buying has kept U.S. interest rates down and caused investors, who wanted to make more money, to aggressively move money into emerging market stocks and bonds over the past couple of years.
The flow of money caused emerging market stocks to soar, and relatively high bond yields attracted bond investors.
Recently, however, the process has moved into reverse. Now, Treasury bonds are yielding about 2.8 percent compared with just 1.6 percent in May. So yields over 4 percent, which come from emerging market bonds, are not as attractive as they used to be compared with ultrasafe Treasurys.
So investors have been yanking money from emerging markets on the expectation that as Treasury yields rise, and as investors see money being pulled from emerging markets, the trend will build. And as money is pulled out and economies slow, investors could become increasingly nervous.
"We expect volatility in U.S. bond markets to persist, with particularly grave implications for emerging market local debt," said Axel Merk, chief investment officer of Merk Investments.
While the move away from emerging markets has been dramatic, some analysts think the greatest decline has already passed. Still, even though Morgan Stanley analyst Joachim Fels said in a recent report that he expects stabilization over the next six to 12 months, there remains the risk of further declines.
"We are lowering our sights on emerging market growth further," and that will also significantly reduce global growth, Fels said.
He had been expecting global growth of 3.1 percent this year. He lowered it this week to 2.9 percent for this year and 3.5 percent in 2014.
Emerging market economies had led global growth after the U.S. financial crisis started the Great Recession about six years ago.
But China was a major engine behind that growth and has slowed recently. The country has been reporting GDP growth of about 7.7 percent recently, far below the 10.4 percent of a couple years ago. Some analysts, who look at plunging world demand for commodities, think China has slowed much more than it is reporting.
As China has slowed, and its need for commodities has declined, emerging markets that produce basic materials have been hit hard.
But it's not just commodity producers that are feeling it. China is a major customer for manufactured and electronic products produced by other Asian countries such as South Korea.
"All eyes are on real rates and China," Fels said. If Chinese growth ends up being just 5 to 6 percent, or if U.S. Treasury bond yields surge to 4 percent, he said, "the likely result, given the still fragile state of emerging markets and the euro area, will be the next global recession."