This is a 'time to reconsider' moment for emerging market (EM) allocators, according to latest Liquidity data. 2016 is the turning-point: after more than five years of lacklustre EM investment returns triggered primarily by poor liquidity conditions and correspondingly high risks, the future is looking significantly better.
The key reason is the notable recent improvement in both the quantity and, more importantly, the quality of, liquidity flows to EM. Not only have both foreign investors' net inflows and domestic private sector liquidity jumped higher (virtually across the geographic spectrum of EM), but the currency sapping dominance of EM Central Bankers has taken a step backwards. Therefore, looking ahead foreign interest in increasing in what are fast-becoming more healthy cash-generating economies, with the prospects of greater future currency stability.
EM debt looks a compelling opportunity, not least because the mix of liquidity is reducing liquidity risks and at the same time underpinning the local currencies
Liquidity is the ability of each national economy to generate cash and, looking forward, EM inflows have taken a decisive step upwards. The charts in Figures 1 and 2 describe the EM Liquidity conditions compared to DM.
Since 2010, DM Liquidity has significantly and obviously outpaced the lacklustre flows into EM. But today there is a clear reversal. June 2016 proved the first time for some years that EM Liquidity outpaced DM Liquidity. Based on past relationships, this is enough to signal a period of upcoming EM outperformance.
Figure 1: Emerging Market and Developed Market Liquidity Conditions, 1980-2016 (Indexes range 0-100)
Figure 2: Emerging Market and Developed Market Liquidity Conditions, 2010-2016 (Indexes range 0-100)
Two investment themes appear to be playing out across EM: (1) the US dollar may have already peaked, and (2) the Chinese economy is expanding faster.
A slightly weaker US dollar helps in a number of ways: For those trade-sensitive EM that peg to the US unit, it improves competitiveness. But it also takes pressure off local policy-makers, who may be reluctant to ease monetary conditions against currency concerns. A weaker dollar typically boosts commodity prices, which helps EM. Finally, a falling dollar encourages greater cross-border lending flows from the Euromarkets into key areas like EM trade finance.
The pick-up in China is equally important as it surpassed the US as the most important economy for EM. For example, the first principal component (a statistical term) of EM capital flows are now unambiguously driven by the Chinese business cycle. But China is picking-up economically, and while double-digit GDP growth rates may well have passed, acceleration back to a sustainable 5-6% trend growth rate would be welcomed. Many investors have failed to spot the recent key inflection in Chinese economic policy following the tightening instigated through 2015. The People's Bank (PBoC) is again expanding credit and fiscal spending on infrastructure is being rushed out.
In short, fast rising commodity prices are a bellwether of the weaker trend in the US dollar and the stronger trend in China: the evidence from Liquidity data show that EM are already similarly tuned-in.
In fact, the new more wholesome character of this EM liquidity improvement is worth emphasising. Figure 3 and 4 show, respectively, the breakdown of EM liquidity into its components - (1) Central Banks, (2) private sector and (3) cross-border flows - and the distribution of cross-border flows between Emerging Asia and Latin America.
The key point that emerges from Figure 3 is that private sector liquidity, which tends to be dominated by swings in corporate cash flows, is heading higher from its long-depressed levels. On top, foreign flows have rebounded smartly from their September 2015 lows, led according to Figure 4 by gathering foreign interest in Emerging Asia.
The lessening relative importance of EM Central Bank liquidity provision points to more stable currency markets ahead, because from experience more 'money printing' tends to weaken currency units, whereas greater private sector profits tends to strengthen them. Since our oft-quoted rule is that every EM crisis is 'first-and-foremost a currency crisis', these greater odds of currency stability surely radically reduce the possibility of another EM sell-off?
Figure 3: EM Liquidity - Breakdown By Component, 2010-16 (Indexes 0-100)
Figure 4: Cross-Border Financial Inflows to Emerging Asia and Latin America, 2010-16 (Indexes 0-100)
Likewise, Latin American markets show greater strength in domestic private sector liquidity, consistent with their commodity price bias and more significant recent currency falls.
Therefore, looking ahead, we should expect foreign interest to 'catch-up' in Latin America and domestic investors to raise their participation in Emerging Asia.
The implications of this improvement in domestic private sector liquidity (relative to Central Banks) and in foreign capital inflows focus respectively on the currency and fixed income markets. From this base, domestic equities should benefit significantly. Debt market performance, as measured by the narrowing yield spread on the Bank of America/ Merrill Lynch emerging market high yield series, should improve directly with greater foreign interest. Figure 5 shows the movements of this spread compared to our index of cross-border inflows (inverted and advanced by 3 months so that it leads).
Figure 5: Emerging Market High Yield Debt Spreads and Cross-Border Flows to EM (inverted), 2008-2016 (BP and Index 0-100)
The implication is that asset allocators should substantially increase their allocations to EM over DM.
EM debt looks a compelling opportunity, not least because the mix of liquidity is reducing liquidity risks and at the same time underpinning the local currencies.
Our key investment preferences for 2016 have and continue to be commodities and credits, but somewhere in this mix there are strong grounds for adding substantially to Emerging Markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.