Flows into emerging markets are likely to remain solid this year, when the dynamics of the ‘risk-on/risk-off’ trade will be “less sharp than in the past 18 months, thus encouraging risk-taking,” HSBC strategists said in their 2013 outlook, published under the headline “Loosen your seatbelts.”
“The risks confronting the global economy have not disappeared; yet, things do not have to be perfect for EM economies and assets to perform well once again,” the strategists said.
“Just enough of a reduction of the most significant tail risks is what is necessary for EM to have another year of strong performance.”
A combination of a “calmer” atmosphere in developed markets and accelerated economic growth should attract inflows into emerging markets despite valuations being “more stretched” than at the beginning of last year, and should lead to credit rating upgrades for some countries, according to the HSBC strategists.
Indonesia, the Philippines, Turkey, Peru, Uruguay, Chile, Mexico, Kazakhstan, Belarus and Latvia are countries that could potentially be upgraded by credit rating agencies this year, while South Africa, Hungary, Ukraine and Argentina could see downgrades, they said.
ECB President Mario Draghi said last week that financial markets had stabilized, while ECB board member and Austrian central bank governor Ewald Nowotny said there were reasons for “cautious optimism.”
In the absence of triggers for the “risk-off” trade, flows to emerging markets will remain strong this year, supported by quantitative easing (QE) by the major central banks such as the Federal Reserve, the Bank of Japan and the Bank of England.
“The different rounds of QE have had a decreasing effect on inflows into EM equities, while its force has been increasing in the case of EM bonds,” they said. “However, China’s improving economic momentum and its expected impact on other EM countries have boosted flows into EM equity funds by the end of last year and the beginning of 2013.”
‘SUSTAINED RALLY’ IN STOCKS
Demand for emerging markets assets will exceed supply “significantly” due to the overall increase of money-seeking assets at a global level, the overall size of the emerging markets asset class being smaller relative to the global pool of financial assets and relatively stronger compared to other asset classes, the HSBC strategists said.
Bonds in emerging markets benefited the most from quantitative easing in the developed world as “each round of easing played more of a role of containing further deterioration, rather than promoting economic activity” and investors went for the more secure asset class, they said.
But the situation is now changing and a pick-up in flows towards equities “appears to have started already.”
“A muddling-through investment environment should encourage positioning in the most volatile portions of the asset class,” the HSBC strategists said. “We also expect emerging markets growth to accelerate in 2013 and 2014, widening the gap with developed markets even further.”
Global allocations to equities are “at a low secular point” so stocks find themselves in “a very good technical position for a sustained rally.”
For bonds, the upside is more limited this year than in 2012 but the returns will remain positive, the HSBC analysts predict.
“Emerging markets hard-currency bonds have matured and became a destination for not only those searching for yield but also for safety,” they added.