Emerging markets have been among the best–performing asset classes in the past three years. They were a literal cash register for investors during a period in which returns in developed markets were modest, at best.

However, emerging markets reversed in the second quarter of 2006 — a watershed event considering the gains they previously turned in. When these markets were flourishing, low interest rates in the major industrialized countries helped compress volatility and risk premiums, encouraging flows into the emerging markets. Strong world growth, especially from raw material intensive producers such as China, helped drive commodity prices higher. This in turn contributed to improved terms of trade for many developing countries.

However, that process is running in reverse now and the virtuous cycles are turning vicious.