Emerging Market Optimism Runs Rampant As Stocks, Inflows Surge

Optimism around the prospects for emerging markets is building.

Developing nation assets have lots of “cyclical catch-up potential,” Deutsche Bank said late last month. Clearly, normalization of global trade and commerce alongside a weaker dollar, accommodative developed market central banks, and an environment that encourages investors to venture out the risk curve for yield, are all conducive to a rally.

Coming into Friday, EM equities were poised for a fifth straight week of gains. Notably, MSCI’s gauge looks to be on the brink of recouping the entirety of losses suffered during the trade war.

That’s no small feat. The short vol bubble burst in February of 2018 and subsequently, Jerome Powell continued down the road to policy tightening, even as Trump escalated the trade war. Of course, protectionism can be inflationary, and Trump was also attempting to overheat the domestic economy at the time, so there was a rationale behind Powell’s double-barreled tightening push. It’s just that he famously overestimated EM’s resilience.

Now, with several COVID vaccines on the way and market participants looking forward to the virtuous combination of more predictable US foreign policy and a Fed that’s pre-committed to keeping rates glued to lower-bound, emerging market bulls are running.

“For every $100 out of EM, financials, Europe, value, and small-caps since January, the past four weeks have seen $36 of inflows,” BofA’s Michael Hartnett wrote Thursday.

The left pane shows cumulative, four-week flows into EM equities. $25 billion is a record, BofA noted.

Hartnett included a warning. The “BofA EM Flow Rule” has now triggered a “sell signal,” he said.

Apparently, that happens when four-week inflows are greater than 1.5% of AUM. There have been 16 such signals for EM since 2007, and the median pullback in developing nation equities has been 3% in eight weeks with a 63% hit rate.