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July 16, 2016 | 13:20| Dubai
Capital flows to emerging markets should continue to recover in the post-Brexit world, according to the Institute of International Finance’s (IIF) July Capital Flows Report.
“The key question for our July report is whether the Brexit vote shock will derail the recovery in emerging markets that we have seen developing over the past six months. The answer is no,” said Charles Collyns, managing director and chief economist at the IIF. “In fact, Brexit could even intensify appetite for EM assets among investors searching for better yields as rates in mature markets fall to ever lower levels, fed by diminishing hopes for growth in mature economies and expectations that dovish G3 central banks will keep policy rates lower for longer.”
Renewed investor interest in emerging markets this year has been supported by initially cheap valuations, particularly for equities vis-à-vis mature markets. Even after their recent pickup, forward price-to-earnings ratios indicate that EM equities are still trading at very low valuations relative to mature markets, and are more undervalued still on a cyclically adjusted basis (Refer to the Chart below). With the growth differential between emerging and mature markets expected to widen during 2016-17, history suggests that emerging markets could experience a further degree of re-rating relative to mature markets.
In fact, valuations for many EM countries in June were only slightly higher than the trough reached in February 2016, excepting a number of Asian countries where they reached significantly higher levels, following stronger price gains. Moreover, recent weeks have seen upward revisions to EM forward earnings estimates, which has helped keep EM P/E multiples low relative to those in mature markets.
More broadly, however, EM earnings appear to be turning a corner. Although still below year-ago levels, trailing earnings have picked up in recent months, while long-run earnings estimates are being marked up—in contrast to mature markets, where long-run earnings estimates have been revised down this year.
EM USD bonds also look fairly cheap relative to their mature market peers, although the comparison is somewhat skewed by extremely low benchmark bond yields. EM spreads for the most part remain well above 2005-15 averages, and not far off their widest levels of the year during the January-February market turbulence. Local currency bond yields also remain near their 2016 highs in most EM countries, reflecting still-elevated perceptions of currency and inflation risk. It is worth noting, however, that EM USD bonds now look much more expensive relative to high-yield bonds, as the latter were hit hard by the decline in energy prices. The pendulum could thus swing back—in the same way that crossover investors moved out of emerging market bonds into high-yield bonds during the 2013 taper tantrum, they could shift towards cheaper high-yield bonds, as the outlook for oil prices stabilizes.