Monetary conditions in emerging markets are at their easiest for at least three years, having improved markedly since May, according to an indicator operated by NN Investment Partners, the Dutch investment house.
The sharp improvement in liquidity conditions has been driven by foreign investors, who are pouring money into emerging market bond funds in particular amid an increasingly frenetic hunt for yield, fuelled by record lows bond yields in the developed world.
“Domestic financial conditions are easier because there have been more inflows due to the search for yield and reasonable Chinese data,” said Maarten-Jan Bakkum, emerging markets strategist at NN IP. “Currencies have appreciated and with lower inflation there has been more room for interest rate cuts.”
NN IP’s monetary conditions indicator was negative (on a scale that runs from -3 to +3) as recently as February, and after a brief rally into positive territory fell back to zero in late May. However, since then it has rallied to 1.05, surpassing the previous peak of 0.95 in April 2015, as the first chart shows.
The indicator is based on central bank policy rates, one-year interest rate swaps, five-year bond yields and real growth in the M2 measure of money supply in the 20 largest emerging market economies. It has been running since 2013.
The dramatic turnround in NN IP’s indicator mirrors that of a longer running emerging market liquidity index calculated by CrossBorder Capital, a London-based financial research company.
CrossBorder’s measure surged to 53.1 in July, on a scale of 0-100, where 50 represents the long-term inflation-adjusted average. This is the strongest reading since 2010, as the second chart shows.
This indicator encompasses the creation of money by central banks, commercial banks and shadow banks, the cash flow of households and companies and net foreign inflows, such as portfolio and foreign direct investment flows. The data are sourced from central banks and finance ministries in about 80 countries.
Michael Howell, managing director of CrossBorder Capital, said the jump in the headline index was driven by “a remarkable” rise in its component measuring net cross-border inflows, which has hit 77.5, “given that in August 2015, pessimism was widespread and the same index stood at a miserable 3.3 points”.
In particular, Mr Howell said that capital outflows from China, which has seen $1.3tn leave the country in the past two years, have now almost abated, with the ending of this capital flight allowing the People’s Bank “to ease and importantly reverse last year’s monetary tightening”.
Mr Howell said CrossBorder’s measure was a leading indicator for economic growth and financial market returns, leading the foreign exchange and fixed-income markets by three to six months, equity markets by six to nine months and the real economy by 12-15 months.
Mr Bakkum was also confident that the easing in financial conditions indicated by the jump in NN IP’s indicator “should help the EM growth recovery to broaden out and strengthen”.
Recent weeks have seen record buying of emerging market bond funds, illustrated in the third chart, as pension funds, sovereign wealth funds and other big institutions have started to react to the desultory bond yields on offer in most big developed countries.
“This is capitulation. The big, big investors are starting to move,” said Sergio Trigo Paz, head of EM fixed income portfolio management at BlackRock, the world’s largest fund manager.
Central banks in Russia, India, Indonesia, the Philippines, South Korea and Argentina have also cut interest rates this year, improving liquidity conditions still further.
Moreover, Mr Bakkum argued that structural improvements in countries such as India, which has approved a long-awaited overhaul of the country’s fragmented tax system to create a genuine single market, and Indonesia, which is cutting red tape, improving infrastructure and implementing “less protectionist” trade policy, should help to increase confidence in emerging markets still further.
His main concern centres on a “recent deterioration” in economic data from China, where “real estate sales growth seems to have peaked, while private investment growth continues to struggle”.
NN IP’s central view is that although China is in a multiyear slowdown, the current pace of this slowdown is “manageable”.
However, Mr Bakkum added: “We continue to think that a deterioration in Chinese growth is the single-most important risk to all EM assets.
So if we talk about the recent resilience of EM debt, we feel that the most remarkable aspect has been that investors have shrugged off the disappointing Chinese data.”
