An old stock market adage holds that "when the U.S. economy sneezes, the emerging markets catch a cold". The notion is that because of the heavy reliance of most emerging market countries on exports to the United States, a slowdown in U.S. demand would be felt more directly by emerging market economies than by the U.S. itself. And for many years this maxim held true. In some ways, emerging market stocks were viewed as magnified plays on the strength of the U.S. economy.

In recent years, emerging market countries such as China, India, and Brazil have worked hard to reduce their dependence on U.S. exports and build more diversified economies. Governments have adopted policies to encourage more domestic consumption, expand their list of trading partners, and build up foreign currency reserves to avoid the kind of currency crisis that crippled these countries in 1998. For the ten years ending in 2012, these changes helped propel the MSCI Emerging Markets Index to a gain of more than 13% annually, versus around 5% for the S&P 500.

This year, the tables have turned. Emerging market stocks have underperformed the U.S. stock market by more than 25 percentage points so far in 2013. As the U.S. economy continues on its modest upward expansion, emerging markets have been plagued by fears of a significant growth slowdown in India, China, and Indonesia. And now, investors are fleeing emerging markets in anticipation of the Federal Reserve's plan to begin slowing the rate of U.S. open market bond purchases sometime in the fall.

Why are emerging markets taking the brunt of the expected change in Fed policy? If the U.S. economy is strengthening (the main reason cited by the Fed in order to justify the unwinding of its aggressive stimulus measures), shouldn't that be good for emerging markets?

In investors' minds, the threat to emerging markets of higher U.S. interest rates is overwhelming the benefits of a stronger U.S. economy. The reason is that many emerging market companies have taken advantage of very low U.S. interest rates to borrow in U.S. dollars to invest in expanding their local businesses. Propelled by their once-strong currencies, they could repay low-cost U.S. dollar debt easily. Now that capital flight out of these countries has severely weakened their currencies (most notably the Indian rupee and the Turkish lira), the cost of servicing this debt has risen dramatically. The fear is that this phenomenon will spiral into another Asian currency crisis, which led to a 52% decline in the Emerging Markets Index during 1997 and 1998.

Our view is that emerging markets are in far better shape than they were in 1998. Most have built up substantial foreign currency reserves, have low debtto- GDP ratios (unlike many developed countries), and still possess growth rates that are the envy of the developed world. In short, they are far less dependent on the U.S. than in the past. While the old adage may still hold some truth, catching a cold from the Fed's sneeze seems far less likely.

Have a great week.

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