By Alexis de Mones
For several months last year emerging markets (EM) bonds were seemingly trading as a leveraged play on financial conditions.
Performance was highly correlated with the price of a two-year treasury futures contract: falling when Fed Funds hikes seemed more imminent, and rallying when this prospect seemed further out in the future. This lasted until September, when the relationship broke down and the global macro data did not matter so much anymore.
A growing focus on the December QE taper, country-specific events (mostly political in nature like in Turkey and Russia), and fears of slower growth in China swept all before them, putting significant pressure on EM equities and currencies in particular. Since March, however, EM assets have been rallying strongly. There are several factors underpinning this renewed strength. We outline four, with apologies to Daft Punk whose 2001 tune (with minor revision) describes them quite well: Softer, Better, Faster, Stronger.
Softer refers to the global economic data and the more dovish policy reaction from the Fed, as well as the ECB’s more dovish stance in the face of lower-than-expected inflation. This has been an important factor behind the most recent leg of the rally, though not the initial catalyst; Better describes the economic policy response by EM officials, starting with the interest rate hikes delivered in Turkey or South Africa in January, which stopped the rot and set the stage for the recent rebound; Faster illustrates the speed of the recent price action in local markets such as Brazil notably, which is forcing investors to cover their short positions and is pushing prices higher; Finally the rally is also Stronger because it is not just a short-covering trade; participation has been broadening from long-term strategic investors to cross-over investors, and finally retail investors, who are returning to the EM asset class (both fixed income and equities) after months of continuous outflows and have posted two consecutive weeks of strong inflows into dedicated mutual funds and ETFs.
So what shall we make of the recent rally in emerging markets? Perhaps the recent rebound in EM performance was predicated on the benign interest rate backdrop and will not be able to survive a string of stronger US data. We don’t think so. The rally in EM assets demonstrated its resilience when it shrugged off the hawkish tone of last March FOMC statement that shaved 25 basis points off the December 2015 Eurodollar contract.
The more striking aspect of recent markets was the out-performance of EM over developed market assets: the 4.7% and 5% month-to-date returns of the Brazilian and Chinese equity indices contrasting with the flat performance of the S&P 500 and the 3.5% drop in the Nikkei.
Beyond the specific characteristics of each of these indices, this divergence is the mirror-image of the market regime that prevailed 6 months ago and one naturally looks for clues in the reversal of portfolio flows that has taken place in recent weeks. Retail fund flows provide a truncated but a pretty timely picture. In the week leading to April 9, EM dedicated equity funds recorded inflows of USD 2.9bn, or USD 5.4bn of inflows over two weeks. Likewise, EM bond funds attracted USD 1.8bn inflows last week, recording the first back-to-back weeks of inflows for the first time since last May.
These are early days and the past trend in flows may not be broken yet, but with flows into EM picking up again, performance and perceptions can change very quickly indeed.
Alexis de Mones is head of fixed income at Ashmore
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