Despite its resounding rally so far, EM financial asset performance will remain robust in the second half of the year, as the external and local conditions that are supporting the current rally are likely to remain in place, believe analysts at HSBC. Murat Ulgen and colleagues note in their July research piece titled “Emerging Markets: Rally’s resilience” that EMs are witnessing record weekly inflows even after the Brexit vote.

Six drivers to propel enhanced EM sentiment

Ulgen and team point out that the U.K.’s vote to leave the EU hurt sentiment only temporarily. They argue that expectations of even further accommodation by core central banks and limited trade and financial links between the U.K. and EMs facilitated investors in using it as an opportunity to build up positions in EMs. The HSBC analysts believe external and corporate hard currency debt will continue to perform well while local currency debt, EM FX, and equities have room to rally as valuations in these markets are still far from the levels witnessed before the “taper tantrum” in 2013, the last time EM sentiment was this strong.

The HSBC analysts believe six major drivers will facilitate improved EM sentiment: neutral to dovish global central banks, a range-bound USD, the re-widening of the EM-DM growth differential, neutral to dovish monetary policy by EM central banks, broadly stable oil and commodity prices and favorable positioning and valuations.

The following table captures how benign global and local conditions boosted EM performance YTD:

EM performance YTD Emerging Markets, EM Rally

They note that considering the hunt for yield and large EM carry, neutral to dovish core central banks and low-for-longer core rates give the most critical support to the EM rally.

Preference for EM fixed income

HSBC analysts enhance capital inflows expectations into EMs to 2.4% of GDP

Highlighting the range-bound USD, Ulgen and team point out that the Federal Open Market Committee sees USD strength as a factor that tightens financial conditions and hence contains inflation pressures and limits growth. The analysts see the stability in the euro and a gradual and managed depreciation in the Chinese renminbi as supportive conditions for EM FX. They argue that the EM-DM growth differential is set to re-widen in EMs’ favor again, while EM macro balances are looking better. The analysts add that China’s Q2 GDP growth came in stronger than anticipated at 6.7%, and several leading indicators for EM growth suggest support for further stabilization / acceleration in 3Q16:

EM-DM gap

The HSBC analysts note that EM central banks are neutral to dovish with room for further easing in their policy stance given the ongoing global disinflationary environment, subdued EM inflation outlook, and a still-large real interest rate differential with DMs.

Room to catch up

The analysts note that resilient oil/commodity prices are also offering support for EM risk through terms of trade, besides reducing the tail risks of financial and credit strains. Ulgen and colleagues add that valuations and positioning suggest that EM assets still have room to rally. They anticipate that the current supportive global and domestic factors will linger in the coming months and, given the current still-attractive levels compared to where they were right before the taper tantrum, along with funds flow positioning and cash holdings, local markets will catch up.

Enthused by recent favorable developments, the HSBC analysts have revised up their expectations for capital inflows into EMs in 2016 to 2.4% of GDP (US$620 billion) from 1.8% (US$500 billion).