China slowdown weighs on emerging markets This is the year of the horse in China which explains perhaps why there are not many bulls around Asia and other emerging markets. Last year developed markets strongly outperformed emerging markets. The MSCI global index was up 24 per cent but emerging markets dragged down the index by a negative 5 per cent, while the high yield index was up 7 per cent, with no thanks to emerging market bonds which were down 7 per cent. Today developed markets are expensive and emerging markets cheap. Many analysts believe though that emerging markets can become cheaper still and that the bull case is far stronger for developed markets. These analysts are advising investors to steer clear of emerging markets. Whether that is the right call depends still on correctly parsing the policies of the Federal Reserve. In fact, the Fed shows no signs of abandoning the easy money policies that have led to a 30 per cent surge in the US stock market last year. Indeed, the net effect of the statements accompanying the announcement of a reduction in asset purchases of $10bn in December was on the easing side with a promise to keep rates lower for longer. That's good news for the fortunate few who live in the Bernanke/Yellen economy as opposed to the rest of us who live in the real economy. And to be fair there are some promising signs of spring in the real economy as well as in financial asset prices. That in turn is feeding into growing confidence on the part of chief executives in the USA, as shown by the sudden surge in mergers and acquisitions. Sadly though for the bulls, there could also be a bearish explanation for these deals. That's because the willingness of chief execs to use shares as currency suggests they believe that their shares are now fairly valued and that their earnings in 2014 may not be too robust. For the past few years, revenues have stemmed largely from cost cutting. But that slash and burn policy is coming to an end. Yet investment in plant and equipment remains minimal suggesting that executives don't see a big increase in demand to help lift earnings. Capacity utilisation remains well below 80 per cent, leaving little incentive for them to invest in anything other than their own shares. As the earnings season gets underway, industrial and technology behemoths including General Electric and Intel are reporting disappointing numbers and retailers such as Target are lowering their forecasts for the year. So if corporate America wishes to increase earnings and support elevated valuations, the best way to do so is by buying earnings through acquisitions. In addition, executives also may feel a sense of urgency because they fear that at some point, the cheap debt to finance any purchase will come to an end, regardless of the Fed's policies and intentions. Still, all this suggests that any recovery in developed markets won't be robust enough to lift emerging markets in their wake. November's US trade numbers, showing a narrowing trade deficit mean fewer dollars are going to the pockets of exporters elsewhere in the world. In addition, any positive pull from the US is likely to be offset by the negative of weaker demand from China. And the more yields rise in the US, the more bearish the case for emerging markets becomes. Equity outflows - what Mohamed El-Erian of Pimco refers to as "tourist dollars" - from emerging markets in 2013 were the greatest in 11 years according to research from Bank of American Merrill Lynch in a research report entitled, "The Slow EM Bleed Continues." BRIC markets are down 54 per cent from their peak. Meanwhile, analysts at Morgan Stanley suggest that while yields have risen in the debt market, carry isn't high enough to compensate investors for the risk and have a "reduce" call on emerging market credit and currencies. Real economic factors and financial factors suggest Asia and other emerging markets will continue to have a hard time. China had a surprisingly big surplus in recent months and added over $500bn to its reserves last year. But that isn't expected to continue. Moreover, the People's Bank of China is one of the few major central banks that is actually trying to rein in credit growth and asset prices. That means the cost of capital will rise in China, leading to less money for its neighbours. Elsewhere in Asia, lower surpluses in some countries and deficits in others means fewer household savings overall to finance credit-led growth. In the first half of 2013, hedge fund managers who were prudent and sought to hedge their positions were made to feel like fools. This year, caution may prove wiser than it did in 2013 whether in developed or emerging markets.