Early childhood growth retardation persists in developing countries despite decades of nutritional interventions. Adequate food is necessary, but not sufficient, to ensure normal growth where there is ubiquitous exposure to infection. Pathways associated with infection, small intestinal mucosal damage and chronic immunostimulation remain largely undemonstrated in countries other than The Gambia. We conducted a longitudinal study of one squatter and one middle-class group (n 86, 3–18 month olds) to assess these relationships in Nepal. Growth, mucosal damage index (MDI; urinary lactose:creatinine ratio adjusted for body weight), morbidity reports, and blood concentrations of albumin, α-1-acid glycoprotein, IgG and Hb, were recorded monthly. Growth status worsened dramatically from 6 to 18 months, with squatters more stunted (height-for-age Z-score (HAZ), P < 0·001) and underweight (weight-for-age Z-score (WAZ), P = 0·009) than middle class. IgG increased with age, was elevated in squatter children, and negatively related to WAZ (P = 0·034). MDI showed significant negative associations with growth performance, explaining 9 and 19 % of height and weight deficits (ΔHAZ, P = 0·004; ΔWAZ, P < 0·001). Unexpectedly, these associations were weaker in squatter children, namely in the group which showed poorer growth, elevated morbidity, greater pathogen exposure (IgG) and higher MDI (P < 0·001). In Nepal, as in The Gambia, children exhibit poor growth, mucosal damage and immunostimulation. The relative impact of pathways associated with infection and undernutrition may, however, differ across socio-economic groups: in poorer children, the impact of mucosal damage and immunostimulation could be masked by nutritional constraints. This has important implications for public health interventions.