Brexit Accelerates EM Flows

Shanny Basar

The UK ’s vote to leave the European Union has accelerated investor flows into emerging markets as July has become only the second month over the past year with EM portfolio flows that are above their long-term average.

The UK referendum on June 23 resulted with a majority voting in favour of Brexit. Portfolio flows into emerging markets increased this month to almost $25bn (€22.75bn) according to a report today from The Institute of International Finance, the trade group of financial institutions. Equity inflows contributed more than half, $14.6bn, while fixed income flows were $10.2bn.

“Flows data corroborate that there was a vigorous rebound in risk appetite in the weeks following the Brexit vote, reflected in a sharp pickup in investor interest in emerging market and other risk assets, as investors digest near-record low global yields,” said the IIF.

This month EM Asia had total inflows of $19.1bn, followed by Latin America with inflows of $8.7bn while, in contrast, there were modest outflows from EM Europe, Africa and Middle East.

“The recovery in flows during the past few months follows a period of exceptional weakness in EM portfolio flows that began with China’s mini-devaluation almost a year ago and saw cumulative outflows of $81bn from EMs, compared to $96bn during the global financial crisis,” added the IIF. “In fact, July 2016 marked only the second month over the past year where portfolio flows were above their long-term average of $22bn.”

L. Bryan Carter, head of emerging market debt, at BNP Paribas in New York said in a blog that emerging markets  assets have performed extraordinarily well and recouped their losses following the  initial negative reaction to the Brexit result.

“Britain’s vote to leave the EU has counter-intuitively accelerated investor flows into EM, by providing an escape from the uncertainty of Europe, offering both carry and underlying duration advantage,” added Carter. “Of course the idea of EMFI acting as a safe haven is preposterous, but geographically EM is far from the epicenter of European political and economic risk. EM countries have limited exposure on aggregate, with EM exports to the UK accounting for just 0.6% of total EM GDP.”

He continued that EM countries with strong links to Europe will be more sensitive and Latin America and the Middle East offer the strongest return opportunities due to their low export dependence on Europe. Carter also warned that investors face potential risks including the impact of a potential interest rate increase from the US Federal Reserve causing a repricing of the underlying yield curve.

BlackRock agreed in a blog that emerging market assets are rebounding following signs of economic stabilization in China, recovering commodity prices and a weaker US dollar.

“The UK referendum, while adding volatility, reinforced some of these trends, most notably driving expectations that the US Federal Reserve would keep interest rates low for longer,” added BlackRock. “And, investors have been looking for ways to distance themselves from develop market -driven volatility. As EM valuations remain attractive, we see more possible upside.”

BlackRock warned that selectivity is key to EM investing and said there were opportunities in Mexican and Indian equities, as well as EM bonds, particularly those denominated in hard currency.

Mexico is closely connected to the United States and will benefit from a weaker US dollar and stabilization in oil prices as major exports are crude oil and vehicles. The fund manager added that Indian economy is turning the corner as lower oil prices have benefitted a country which imports nearly three quarters of its oil while there is continued policy progress in structural reforms.

“EM debt is offering yields of above 4%, and despite a strong year-to-date performance (more than 13%), we see potential for significant income with lowered spread risk, given the diminished expectations of a near-term Fed move,” added BlackRock. “More importantly, EM fundamentals have shown signs of improvement in many areas, including financial conditions and external balances.”

Scott Berg, portfolio manager at T Rowe Price, said in a note that Brexit had added to geopolitical complexity and investor concerns on whether global corporates can deliver better earnings in a more modest growth world. “As further bottom-up improvement has been called into question, top-down factors, including the outlook for China, concerns over Europe, and volatility in energy and commodity prices, have taken center stage in driving stock prices,” he added.

However he continued that investors worried about interest rate rises believe that Brexit has deferred rate hikes. Berg said: “Regardless, macroeconomic concerns will persist in the near term as investors put more weight on these issues rather than on the underlying fundamentals of individual companies.”

T Rowe Price was modestly overweight the UK and modestly underweight continental European stocks before the UK referendum.

“Our pan-European holdings are heavily tilted toward quality, durable growth companies that either source their revenues globally or have leading business franchises in their core markets,” Berg added. “We will be accounting for any fundamental changes resulting from Brexit via our stock-by-stock decisions but do not expect to make any large-scale changes to the strategy.”

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