Inflation in emerging markets

in many emerging-market countries, inflation is already running near the top of official target ranges. Indonesia and Turkey are seen at risk of falling behind in the inflation fight—if they haven't already—which could force much more aggressive rate increases down the road. This is especially bad news for bond investors, who see the value of their fixed-income returns eroded as inflation rises.

"We currently view overheating within the emerging-market complex as the greatest macro peril facing the global economy," Michael Shaoul of Oscar Gruss & Son wrote in a research note Friday.

Even before scenes of pitched battles in the streets of Egypt dominated the news, investors were growing nervous about inflation, turning tail on some markets. For the week that ended Jan. 26, emerging-market stock funds suffered their biggest spell of withdrawals since the third quarter of 2008, according to EPFR. The MSCI emerging-markets index has lost 2% this year even as the Dow Jones Industrial Average is up 2%.

While most of the moves in emerging markets haven't been big, they mark a change in the outlook from 2010 when their fortunes seemed much brighter than that of struggling developed markets.

Many observers are especially cautious about the near-term outlook for bonds denominated in local currencies. This had been a particularly popular investment in 2010.

With interest rates near zero in the West, investors bought higher-yielding bonds in places such as Indonesia, India and Brazil. As these economies grew, the theory went, monetary authorities would lift interest rates, which would attract even more investors, forcing up currency values and giving an added boost to returns.

Wall Street Journal