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EM flows surge but downgrade risk persists

The week ending July 15 was the strongest week for portfolio inflows to emerging markets since the US Federal Reserve delayed quantitative easing tapering in September 2013, according to the IIF. EM investors believe we may yet continue to see strong flows as US growth continues trending higher, but EM downgrades could still throw a spanner in the works.

Jul 20, 2016 // 2:12PM

The week of July 11 saw just under US$3bn net inflows into bonds from seven EM countries tracked by the IIF – India, Indonesia, South Korea, Thailand, South Africa, and Brazil. That doesn’t include a record week for Argentine issuers, which captured close to US$3bn in portfolio flows from fixed income investors. Flows have slightly favoured sovereign over corporate debt, which could be a reflection of increased FX volatility in EMs.

Overall, non-resident portfolio inflows into the seven EMs tracked by the IIF reached US$12bn since June 23.

Global bond funds – both DM and EM – have attracted more than US$22.5bn while global bond ETFs have attracted more than US$15bn over the past three weeks as post-Brexit anxiety prompts investors to search for yield in safe haven assets. During the same period equity funds recorded net outflows of over US$9bn.

Capital flows into emerging markets have in recent weeks received a strong boost from a flattening of the expected path of interest rate hikes in the US, with hopes for further easing from a number of the world’s largest developed market central banks – the Bank of England, Bank of Japan and the European Central Bank – remaining high.

 “Despite steady inflows, investors maintained underweight (UW) position in Philippines, China and India while keeping broadly neutral weights in Turkey, Russia, and Brazil,” the IIF said in a statement.

Emerging market investors say we could be in for yet more weeks of positive EM inflows as a lower-longer rate environment gets priced into DM assets, prompting more investors to continue searching for yield in emerging markets. Longer US Treasuries have been on the rise for the past two weeks, with yields on 10-year notes rising from 1.3579 to 1.5646 between July 8 and 19, substantially lower than their peeks last November at 2.3436.

Lower US Treasury yields driven by a flight-to-quality move as part of a broader risk-off tend to be negative for emerging market debt, but US Treasury correlations with the performance of EM debt aren’t always clear as recent events show. Thomas Christiansen, an EM sovereign debt portfolio manager at Nordea Asset Management explained that following the Brexit vote, US Treasury yields collapsed – caused by a risk-off move, which was bad for emerging market debt – but US Treasury yields did rally quite a bit intra-day following the initial shock and began rising again briefly for the week after the vote. Until last week, US Treasury yields traded lower again as the Fed was increasingly being priced-out, which actually led to very strong performance across emerging market debt.

“Last week was very strong for emerging market debt, and the past two weeks have been the strongest in more than a year,” he said, adding that stronger growth in China has also contributed to positive sentiment around EMs.

Despite stronger inflows over the past 5 months, downgrades have hammered emerging markets this year, which could be detrimental to EM flows. There have been 16 EM rating actions so far in 2016, and 15 of them were negative, according to analysts at BBH, a New York-based investment house. What remains to be seen is whether the recent events in Turkey will indeed lead to sovereign downgrade by one of the major rating agencies – and, if it comes to pass, contagion within emerging markets.

Both Turkey and South Africa are at risk of losing their investment grade statuses this year, the former scheduled for review by Moody’s in two weeks and the latter, having already survived a rating review in June, on track for another review in September. Downgrades in these two countries would prompt significant outflows and dent emerging market sentiment.

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