Has the tide turned for emerging market flows?

Men look an electronic board showing stock information at a brokerage house in Beijing, China, January 5, 2016.
Kim Kyung-Hoon | Reuters

One of the most bruised asset classes in financial markets may be about to turn a corner.

Emerging markets have had a horrid few years as investors pulled funds amid the prospect of weaker growth in once-booming economies, volatility in China's markets and likely higher interest rates in the U.S. In 2015, capital outflows from emerging markets were the heftiest since the late 1980s.

Now, there are tentative signs of recovery.

Fund flows into emerging markets turned flat in February after seven straight months of outflows, according to data from the Institute of International Finance released on Monday.

"We estimate that the reversal of portfolio flows which began in July 2015 all but stopped in February, with outflows dwindling to $200 million," the global financial industry association said. Outflows of $1.1 billion from emerging market equities were offset by inflows of $900 million to emerging market debt markets, it said.

The IIF attributed February's reversal to "an unusually large" shift in market expectations away from anticipating the U.S. Federal Reserve would hike interest rates as many as four times this year to forecasts that suggested the central bank could stay on hold or even cut rates.

China's RRR cut shows yuan, outflow worries easing

Stanching the outflows in February came despite a volatile month for emerging markets.

"The path during the month followed a roller coaster ride of risk appetite," the IIF said. "In early and late February, oil prices rebounded, equity prices rose, and measures of volatility moderated. In between those periods, we saw moves in the opposite direction."

There are some signs February's flow reversal might not be a one off, with analysts turning more positive on emerging markets.

On Monday, Bank of America-Merrill Lynch said it was ending its bearish call on emerging markets and shifting to a "tactically bullish" stance.

BofA-ML points to some key changes in the economic outlook: "U.S. data are better, Chinese monetary policy is easy, and leads emerging market purchasing managers indexes, which correlate with emerging market/Asian equities."

Another change is that policymakers are starting to look livelier, the bank said in a note Monday.

"Policymakers have begun to show less indifference to the 'dark message of the markets' and more flexibility," the bank said. "In the past few days, Governor Zhou Xiaochuan of the People's Bank of China (PBOC), Governor Haruhiko Kuroda of the Bank of Japan (BOJ), and Federal Reserve thinker James Bullard and Dallas Fed (President) Robert Kaplan have all come up with soothing monetary policy views, in line with our concerns that markets are (performing) consistent with serious deflation and earnings recession risk."

Currency exchange rates in central Moscow, Russia.
Pimco advisor Research Affiliates calls emerging markets 'trade of a decade'

After the BofA-ML note was published, the People's Bank of China (PBOC) announced late Monday that it would cut banks' reserve requirement ratio (RRR) by 50 basis points, in a measure aimed at boosting liquidity as well as capital investment.

Saying it "applauds" the change, BofA-ML said it's going bullish on emerging market cyclical stocks, while selling defensive ones, such as the staples, healthcare, utility and telecom sectors.

Markets globally have shuddered over the past few months, with emerging markets particularly hit by outflows, amid concerns over China's slowing economy as well as whether the U.S. Federal Reserve would tighten monetary policy too quickly. The MSCI Emerging Markets stock index is down nearly 7 percent year-to-date and more than 25 percent over the past year.

But BofA-ML also noted it still has longer term concerns over Asia and emerging markets, such as record-low earnings margins, relatively high valuations, record-high private sector debt to gross domestic product (GDP) and high valuations as well as concerns over China's debt and policy challenges.

It's also concerned that the consensus remains "exceptionally bearish" and may sell on any rally.

"This consensus bearish view could be now a short-term risk to performance," it said.

BofA-ML isn't alone in turning more positive on emerging markets.

Last week, Citigroup also upgraded emerging market equities to overweight.

"As our foreign-exchange strategists no longer forecast a strong U.S. dollar, this should remove one of the major headwinds for emerging-market equities," Citigroup said in a note last week. "The structural problems emerging market economies are facing are still significant but we think a lot of bad news is already in the price, perhaps more so than in developed-market equities."

It expects the MSCI Emerging Market index will rise around 10 percent in U.S. dollar terms by end-2016.

On Tuesday, the index was at 740.33; Citi's year-end target is 820.

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1