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Emerging markets: Bouncing back or further to fall?

Emerging market equities saw their first inflows in more than three months last week, as the likelihood of the U.S. Federal Reserve hiking interest rates before the end of the year eases off, lending some confidence to investors looking at the region.

EM stocks saw $700 million of inflows last week -- a 14 week high -- according to data from Bank of America Merrill Lynch, which used figures from fund flow tracker EPFR, with chief investment strategist at the bank Michael Hartnett declaring "EM is back".

A clerk stacks bundles of Indonesian 100,000 rupiah banknotes at a currency exchange office in Jakarta, Indonesia.
Dimas Ardian | Bloomberg | Getty Images
A clerk stacks bundles of Indonesian 100,000 rupiah banknotes at a currency exchange office in Jakarta, Indonesia.

The flows mark the first signs of rotation to "weak U.S. dollar" plays, including commodities and emerging markets according to Hartnett, with junk bonds also getting a major boost from the "collapse in Fed hike expectations".

But while this is a positive initial sign, emerging markets have nonetheless had a torrid year.

EM outflows are on track to exceed inflows this year for the first time since 1988 amid concerns surrounding the Chinese economy, a currency sell-off and higher interest rates in the U.S.

Investors are estimated to pull some $540 billion from developing markets in 2015, according to the Institute of International Finance based on data for 30 nations that was published at the start of the month.

Foreign inflows will fall to $548 billion, about half of last year's level and below the amounts recorded during the financial crisis in 2008.

At the same time, local outflows are accelerating amid heightened market volatility, pushing net flows into negative territory, the data showed.

More economic data published on Monday showed China's economy grew at its slowest pace since the global financial crisis in the third quarter, reviving expectations of further stimulus to avert a stalling of the world's growth engine.

The world's second largest economy expanded by 6.9 percent in the July-September quarter, slowing from a 7 percent increase in the previous quarter. The numbers might still be better than market expectations, but there is still a cloud over expectations for EM flows and stability for the rest of the year.

Head of research at emerging market investment house, Ashmore, Jan Dehn said the magnitude of EM outflows so far this year following the rout in commodity prices is "substantially lower" than the numbers that have been reported, and much of the blame can soley be laid on China fears.

"Almost all the capital outflows from EM have been due to China. Chinese corporates borrowed heavily in USD in the last few years, but the recent adoption of a more flexible approach to the currency has triggered a significant portfolio shift as corporates have sought to close their net short U.S. dollar positions, "Dehn said.

"Net of China, the EM outflow story has been one of relatively modest net outflows in 2014 and 2015," Dehn added.

Some media reports published in August suggested that EM had suffered $1 trillion in outflows over the last year or so, with Dehn arguing that the real figure is actually somewhere in the region of $200 billion-$300 billion.

After the Federal Reserve failed to raise rates in September, market consensus for the timing of the first interest rate in over six years has shifted to early 2016, with many analysts eyeing March, which is a bonus for emerging market sentiment.

But even with the aid of a dovish Fed, EM fundamentals "continue to deteriorate", head of EM strategy at Societe Generale, Guy Stear, as growth prospects do not look rosy.

The fall in commodity prices is of particular concern to oil exporter budgets , he said, estimating that the weighted average EM fiscal deficit should widen to 4.3 percent of GDP this year, from 2.6 percent in 2014. With a number of countries including Turkey, Kazakhstan, South Africa and Chile all facing renewed "significant" downgrade pressure.

"When considering other factors, including fiscal position, debt burden (public and external), the level of foreign investments, the change in FX reserves and the state of the banking sector, we find that all these fundamentals are deteriorating," Stear said.