Capital Flight from Emerging Equity Markets

The MSCI Emerging Markets Index is down almost 10% so far this year, while the S&P 500, a broad measure of U.S. equities, is up more than 16%. Emerging market equity funds saw their largest outflow of the year with investors pulling $5.76 billion last week, according to data provider EPFR Global.

Stuart Oakley, Managing Director of Asian currency trading at Nomura said the emerging market sell-off has only just begun, and he expects the withdrawal of funds to accelerate when the Fed starts tapering on easing in September.

Confidence is Shot

Investor confidence in emerging markets is continuing to plummet, with a recent fund managers' survey by Bank of America Merrill Lynch showing that equity investment in the group of countries has fallen to its lowest level since December 2008.

The BofA Merrill Lynch Fund Manager Survey for June showed that about 9% of asset allocators were underweight emerging market equities - the first underweight reading since 2009 and down from a 3% overweight position in May.

"A net 25% of the global panel say that emerging markets is the region they would most like to underweight in the coming 12 months - the lowest ever reading," the BofA Merrill Lynch report said.

Why though? It has to do with tapering again. US yields and strong dollar put EM returns in the shade especially when translated to USD/EUR.

China towards 7% Growth?

The bearish sentiment towards emerging markets is tied to investors' growing belief that a hard landing in China is now the greatest tail risk to global markets, according to the survey. About 31% of the regional fund managers said that China's economy will weaken in the next 12 months, compared with 8% in May.

"The biggest contrarian play in the market today is assets linked to China. The lows in emerging market equity and commodity allocations suggest the market has over-positioned itself for a shock from China," Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research said.

Fears of a slowdown in the world's second largest economy has led several major banks and international agencies in the past month to downgrade their growth forecasts for China in 2013, with some even calling for gross domestic product (GDP) to dip below 7% in the second half of the year. China's official target for the year is 7.5%.

China consumes 40% of the world’s copper. The metal’s prices are down 14% this year and inventories are up, which would seem to confirm China’s slowdown.

Added to the bearish sentiment on China are the poor showing of the other BRICS and the so called “next 11” with riots in Brazil and Turkey.

Where's the Money Going?

As investors pull out of emerging markets, European equities are becoming more attractive, according to the BofA Merrill survey, which showed 6% of fund managers overweight the region's stocks in June, a 14% swing from May when 8% were underweight.

"Equity allocations increased month-on-month across 13 of the 19 sectors assessed in Europe. The greatest positive swings came in telecoms, financial services, banks and chemicals," the survey said.

Optimism within the region rose the most in the month, with 45% of European respondents expecting the euro zone economy to strengthen in the next year, up from 24% in the previous month.

"Investors can now see a certain level of stability returning to Europe's economy and positioning for a recovery has started," said John Bilton, European investment strategist at BofA Merrill Lynch Global Research.

Latest upbeat European PMIs from France, Germany, and the entire Eurozone underscore this optimism.

Main article by CNBC.com's Rajeshni Naidu-Ghelani edited by

David Ryder MA MBA

Consultant. Commentator. Entrepreneur.

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