Emerging markets now appear to be the most popular trade of the second half. Investors have been ploughing money into emerging market equity and debt funds over the past few months, taking the total value of assets invested in emerging market fund to some of the highest levels on record. According to Bank of America, Merrill Lynch’s retail investor asset flows data, between 8 August and 18, August investors added $5.1 billion to emerging market equity funds, bringing the total of the last seven weeks to $14.6 billion, the most impressive run since September 2014. Meanwhile, emerging market debt funds saw inflows of $2 billion, taking the inflow total over the past seven weeks to $20.2 billion, the largest figure on record.

Flows Show Risk-On Mood Among Investors As Equity Inflows Soar

Hedge funds are also getting in on the action. According to cross asset flows data analyzed by Bank of America Merrill Lynch’s global market analysis team for the week to August 18, asset managers increased long positions in the MSCI emerging market index futures by $1.6 billion to $17.4 billion last week — now the largest long position on record. Leveraged funds increased their longs on the MSCI emerging market index futures by $0.4 billion to $5.1 billion also an all-time net high.

Hedge Funds Add To Record Emerging Market Longs

Retail investors and fund managers seem all too happy to pour money into emerging markets but analysts at Deutsch Bank aren’t convinced. In fact, the bank is advising clients to take a cautious approach emerging equity markets as valuations become disconnected from the fundamentals.

The emerging market recovery may struggle to gain traction 

The emerging market growth story has reignited investor interest this year. While economic growth in developed markets remains elusive, emerging market growth excluding China relative to developed markets has rebounded by 150 basis points over the past year from -0.6% in Q2 2015 to 0.9% in Q2 this year. Other indicators also point to improving emerging market fundamentals: the relative emerging market composite PMI new orders has risen to a three-year high, the emerging market (ex China) current account is back in balance (compared to a large deficit in 2013) and EM short-term external debt has fallen sharply over the past year.

As a result of these improving fundamentals emerging market equities have outperformed developed market equities by 5% over the past year, the highest level of outperformance since the emerging market bubble in 2011. However, despite a slight improvement in the figures and optimism surrounding emerging market assets Deutsche Bank highlights five speed bumps which could derail the emerging market recovery story. The bank’s analysts explain:

The commodity dependency remains

“The rebound in relative EM (ex China) growth is largely explained by the 30% rebound in real metal prices since end-2015. We see downside risks for metal prices from current levels, given the fading in the Chinese credit impulse and the risk of renewed USD strength. We note that despite their sharp fall over the past five years, real metal prices remain 25% above their long-run average.”

Emerging market economies are dependent on China

“EM (ex China) growth tends to lag Chinese GDP growth by one quarter and our economists expect Chinese GDP growth to slow from 6.7% in Q2 to 6.4% in Q4, which should weigh on EM (ex China) growth going forward.”

Emerging market economies are dependent US monetary policy

“EM portfolio flows tend to follow the US yield curve (a proxy for US monetary policy) with a two-year lag – and with the yield curve now at the flattest since 2009, suggesting the recent easing of EM financial conditions on the back of renewed inflows might not last.”

Leverage remains high and growing

EM (ex China) non-financial private-sector debt to GDP is 9 percentage points above the longrun trend and non-financials’ net debt to EBITDA is at the highest level since the late 1990s. This points to the need for deleveraging, which should further weigh on the already-weak credit impulse.”

Export growth remains anaemic and the aggregate emerging market government deficit is at a 20-year high

“EM export growth remains anaemic – and export PMIs suggest this sluggishness will continue. The aggregate EM government deficit, at 4.6% of GDP, is at a 20-year high, pointing to limited scope for fiscal easing.”

Emerging Markets, Emerging Market Recovery

Emerging Markets, Emerging Market Recovery

Emerging Markets, Emerging Market Recovery