There has been a lot of focus on flows to emerging markets (EM) in general and to EM debt in particular in recent weeks. Research published by various investment banks (including JP Morgan) shows that flows have turned around sharply after a poor start to the year. In this blog, we’ll have a look at the composition of the flows to EM debt and we’ll try to gauge how much scope there is for continued inflows in the coming months. All flow numbers have been pulled together by GFICC Applied Research and a big thank you goes to Frederick Bourgoin and Bhupinder Bahra and team for providing the daily flow data.
The big picture – flows are up this year
As the chart below shows, flows to dedicated EM bond mutual funds and ETFs are up this year. They have been mainly driven by inflows to sovereign hard currency funds, which turned around in early February, moved into positive territory by mid-March and have been steadily increasing since then. Corporate and local currency flows turned around with a month lag, but subsequently took longer to recover to positive territory. Flows to blended EM debt funds, on the other hand, have remained negative in the year so far.
Intuitively the flow pattern makes sense in our opinion. Risk-reward has been most attractive in EM sovereign and hence it attracted most of the inflow. Flows to EM corporate were initially affected by concerns surrounding credit quality and commodities, but once the latter stabilised and Brazil spreads widened to above 1000bps, money started to pour in. Momentum has visibly picked up since late June, suggesting that investors are probably less concerned about credit quality than earlier in the year. Flows to EM local currency bonds have been mirroring this year’s fluctuating views on Fed policy, the US dollar, EM growth and inflation patterns.
Flows to EM debt returning after the outflow in 2013 – 2015, but still well below peak levels
Source: J.P. Morgan Asset Management, GFICC Applied Research Team. Flows incorporate Mutual Funds and ETFs. Data as at 30.08.2016.
The flow pattern, including the outflows from blended funds, also supports the view that EM debt has been a beta trade so far this year. Given the momentum and investor positioning (which we’ll discuss below), this looks likely to continue, but surely one of the key questions on investors’ minds has to be when this could switch to an alpha market.
For how much longer can inflows carry on? First, cumulative flows to dedicated EM debt funds are still some USD 35bn below the long-time peak in May 2013. In fact, they’re still below 2014 levels, which lends support to the view that there is room for more inflows. The latest J.P. Morgan EM investor positioning survey also supports this view, but offers a differentiated picture. According to this, allocation to EM sovereign is close to its long-term high. EM Local Rates and FX are still well below long-term highs and allocation to EM corporate was still underweight in August.
We mentioned above that the year-to-date flow pattern suggested a beta market. The growing importance of ETFs, especially in EM sovereign and local currency, would suggest that beta will remain dominant in the foreseeable future. Even sovereign valuations, which have visibly tightened since the beginning of the year, leave room for more upside. As the chart below shows, it still pays to buy EM sovereign debt at current spread levels on a two-year view.
Again: It still pays to be long emerging markets debt.
Source: J.P. Morgan Asset Management, July 2016. EMBI Global Diversified: JPMorgan Emerging Market Bond Index, Global Diversified.