Emerging markets will suffer accelerated debt outflows if Brazil receives a sovereign credit downgrade, says Deutsche Bank.

In their weekly fund flows report, Jan Rabe and Adrian Rott of Deutsche Bank, also point out that developing market equities continued to enjoy strong inflows.

Brazil’s host of problems

The Deutsche Bank analysts point out Lat-Am’s largest economy is running the biggest budget deficit since 2009 and facing a host of problems. To just name a few, the analysts point out Brazil’s inflation is still out of control, the yield on government debt is showing a rising trend and the country is facing a growing backlog in its reform initiatives.

The analysts note debt fund flows in Lat-Am have flipped since mid-2013 after almost four years of strong inflows, thanks to Brazil’s upgrade to Investment Grade in 2008. The following graph illustrates cumulative flows / AUM into LatAm debt funds:

Brazil

The analysts point out we should anticipate strong outflows on a much larger scale should Brazil indeed be downgraded, as many EM debt holders would then be forced to eliminate their positions due to regulatory constraints.

Deutsche Bank analysts note as Brazil would be the first BRIC country to lose its investment grade rating, LatAm/EM debt would come under significant pressure if such a downgrade happens. They also anticipate volatility would most likely be on the rise following such an event.

DM experience large inflows

Jan Rabe and Adrian Rott of Deutsche Bank, on the other hand, note total equity funds witnessed high inflows again after a hiatus of two weeks backed by strong flows into DM equity funds, particularly in U.S. equities. The analysts point out from the DM space, equity funds witnessed 9-week high inflows as equity indices across DM rallied last week.

However, Japan equity funds posted outflows for the first time after ten weeks of inflows in line with slowing earnings upgrade momentum. Similarly, EM equity funds witnessed redemptions despite the recent market rally after China’s major reform initiatives.

EM debt funds witness outflows

The Deutsche Bank analysts also point out flows into total bond funds turned positive again thanks to huge inflows witnessed in US bond funds, which saw 0.2% growth — the highest inflows since mid-May 2013.

However, EM debt funds continued to witness outflows. The analysts point out in 25 of the past 26 weeks, EM debt funds witnessed at least -0.6% in redemptions.

The following graph highlights the cumulative flows / AUM into Total EM debt funds:

Cumulative flows into EM debt funds