Time to get bullish on emerging markets

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Following a poor performance in December, emerging market (EM) assets look undervalued and could draw investor interest again, analysts say.

"Emerging market assets had a rough month in December and saw outflows of around $8.5 billion," said HSBC rates strategist Himanshu Malik. "But excess liquidity provided by the Bank of Japan and European Central Bank's quantitative easing programs has improved sentiment, and investors are returning – although they are being more selective."

In January, offshore investment into emerging market bonds increased in the majority of EMs, according to a HSBC research note published last Friday. The most notable inflow, of over $1 billion, came from Japan's retail investors.

Institutional investors are also optimistic about the outlook for EM assets, according to a note by Societe Generale head of emerging markets strategy Benoit Anne, published on Friday.

"An overwhelming 74.4 percent of investors had a bullish bias (in February's EM investor survey), which is comparable to the level registered back in March 2014," he said, "and hedge funds are now more bullish than real money investors over the near term."

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In January, Japanese retail investors poured $428 million into Brazilian bonds, and another $516 million into Singaporean, Mexican, Indian and Indonesian bonds, according to the HSBC note citing Ministry of Finance figures. By comparison they spent $953 million on U.S. bonds.

"Japanese retail investors expect the yen to weaken further and are preemptively placing their money into higher yielding overseas assets," said Nomura FX analyst Motoki Kike.

Nomura expects the yen will weaken to 125 against the U.S. dollar by year end, from around 119.85 on mid-day Monday.

International institutional investors for their part may have turned positive on some but not all EM asset classes: they're still negative on currencies, according to SocGen's Anne.

EM currencies have mostly depreciated against the U.S. dollar over the past month, according to a Capital Economics note published on Friday.

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Since the beginning of February, the Brazil's real has lost more than 12 percent and the Indonesia's rupiah, nearly 4 percent, against the U.S. currency.

Upside on the horizon

Another supportive signal is that 44 percent of the investors surveyed feel they are underinvested in EM assets, and their risk position should be raised if they align their allocation to sentiment, according to SocGen's Anne.

And there is upside to EM stocks, say analysts: "After a tough end to 2014, emerging market equities have continued to pick up over the past month," said Capital Economics chief markets economist John Higgins in last week's note.

The seven Asian markets excluding Japan, for example, saw net outflows of $5.85 billion in December 2014, but saw inflows of $9.94 billion so far this year, according to a Nomura Asia-Pacific fund flow note.

Now, the valuations of emerging market equities appear much more favorable than those of developed markets equities, Capital Economics' Higgins said. The MSCI Emerging Markets Index's price to 12-month forward earnings ratio, for instance, is around five points below that of the MSCI World Index of developed market equities.