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Emerging countries : a not so surprising recovery in portfolio investments

7/19/2019

Growth slowdown in emerging economies seems at odds with the strong rebound in portfolio investments observed since Q42018. How can we analyze this seeming conundrum ?

François FAURE

TRANSCRIPT // Emerging countries : a not so surprising recovery in portfolio investments : July 2019

In Emerging Countries, growth slowdown is still on-going and is now across-the-board. In China and India, growth stood at historically low levels respectively in 1Q2018 and 2Q 2018 and Brazil is on its way to recession..Main reasons: the structural slowdown in China and the trade war between China and the US. As a matter of fact metal prices and oil prices are trending downward since respectively mi-2018 and Q4 2018.

In this context investments in EM funds have rebounded markedly since mid-2018. Net flows to EM bond funds, now mainly in local currency, account for 85% of the upturn and net flows to EM equity funds account for the remaining 15%.

How can we explain such a discrepancy between economic performance and portfolio investment flows? To answer this question, let’s review the main factors that drive portfolio investments.

The main factors that drive portfolio investments are actually the ones involved in carry trades. What is a carry trade? The investor borrows in a relatively cheap currency (that is in a currency with a low interest rate), called the “funding currency”, and invests in higher yielding assets (emerging debt or emerging equities in our case) that are usually denominated in local currency. In doing so, the investor is exposed to fx risk. Thus a carry trade can be considered as a speculative arbitrage.

The main factors involved in carry trades are the yield of the assets, the interest rate of the funding currency and fx volatility. The latter two parameters are at play in bond based-carry trade and equity-based carry trade while economic growth seems to only be a determining factor for equity-based carry trade.

Since mid-2018, determining factors of bond-based carry trades have moved in the same direction; even if the cost of US borrowing has increased, interest rate differentials have remained largely positive and, with a few exceptions, FX volatility has reduced. The recovery in investments in EM bond funds is not surprising. May be it has been a little excessive. As regards equity-based carry trades, determining factors have moved in opposite directions: negatively for economic growth and cthe ost of US borrowing, positively for FX volatility. Again, this situation is consistent with a much more mitigated recovery in EM equity funds.

In the coming months, anticipations  of monetary easing in the US should support bond-based carry trades considering monetary policies in EMs will remain very cautious. As regards equity-based carry trades, the impact of growth slowdown will continue  and may even worsen. For both asset classes, there is obviously a risk of backlash in case of intensified political noise.

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