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Nomura - EM Forgotten Inflows - 2012-01-31

Nomura - EM Forgotten Inflows - 2012-01-31

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Nomura |EM FX Insights31 January 2012
Nomura International plc
See Disclosure Appendix A-1 for the Analyst Certification and Other Important Disclosures
Fixed Income Research
Contributing Strategist
Olgay Buyukkayali
+44 (0) 20 710 23242olgay.buyukkayali@nomura.com
This report can be accessed electronicallyvia: www.nomura.com/research or onBloomberg (NOMR)
 
EM FX Insights
Emerging Markets Research | EEMEA
 
EM's Forgotten Inflows: To Rise Like thePhoenix
31 JANUARY 2012
2012 outlooks for many (including us) have been paved (rightly) withbearishness on eurozone deleveraging. There is an unprecedented corollaryto this theme, however, which is the lack of safe assets. Recently, thecorollary is becoming increasingly more pronounced with the factorsdetermining global private asset allocation favouring EM strongly.Furthermore, we got a further bonus: 1) EM local and sovereign bonds had avery strong start to the year (Figure 1)
2) past performance drives futureflows if history is a good guide (Figure 2). In a world of solvent developedbond markets showing a similar price action to the JGB market of the late1990s and solvency becoming a key factor for allocation, we expect areacceleration into EM bond fund flows in the next few months.Investors should be ready to hear the “lack of assets to park our money” talksoften in the upcoming months as the asset allocation continues to shifttowards EM fixed income. Two of our top recommendations aim to benefitfrom this theme are: 1) R157 in local markets (seelink), 2) Turkey17s insovereign bond markets (seelinkandlink).
What determines bond flows to EM?
The latest globalIMF Financial Stability Reportlooks at what determines theinflows to EM. One of the biggest drivers for both equity and bond flows isimproving GDP prospects. Global risk appetite and country risk also matters – improving flows. Interest rate differentials in most cases have no statisticallysignificant effect on flows into equity and bond funds. Similarly, capital controlmeasures show weak effects.The study signals that the crises had some enduring effects on investorbehavior. While investors have become more risk-conscious – including risksaround sovereign credit and liquidity – there is also an increase in secularinflows in EM due to 1) diversification needs, 2) better economicclimate/performance of EM, 3) resilience that has been tested in the post-
Fig. 1: US Treasury and EM bond returns
Source: Nomura, Bloomberg, JP Morgan
Fig. 2: EM fund flows and bond returns
Source: Nomura, Bloomberg, EPFR
 
405060708090100110120130Jun-10Nov-10Apr-11Sep-11US Treasury Total ReturnEM GBI Total ReturnIndex (Jan2012 = 100
)
R² = 0.2879-15000-10000-5000050001000015000-40-2002040Rolling 12week returns(1 month lag)Rolling 12 weekfund flows (US$mn)
 
Nomura | EM FX Insights 31 January 2012 
2Lehman crises, 4) A debt dynamics picture that is looking dramaticallydifferent (in a very positive way) for EM.
Fig. 3: S&P EM Credit Ratings (moving up)
Source: Nomura, Bloomberg
Fig. 4: S&P DM Credit Ratings (moving down)
Source: Nomura, Bloomberg
What has changed in favor of EM?
Recent improvements in global risk appetite and a lack of evidence of a hardlanding in EM are the two big checkmarks for reserve managers andinstitutional investors who do not currently have a major exposure to EM, buthas got a big exposure to the eurozone. Furthermore, the credit ratingagencies are moving slowly with a clear direction (Figures 3 and 4). Therecent credit and debt dynamics outlook changes are also making it moredifficult for institutional investors to have a portfolio with a very high weight onDM markets. The conflict here is that such a portfolio that ignores EM fixedincome in particular does ultimately ignore the return “off” the money objectivefocusing too much on return “on” the money. In other words, credit rating,debt dynamics (Figure 5) and outright yields is proving that it is ultimatelybecoming riskier to ignore EM. This is a longer term factor which iscomplementing the short-term pull factors to EM, such as growthoutperformance and recent pick-up of global risk appetite (and collapsingvolatility).
An example of return “off” the money from the past 12-months
Time and duration of the DM’s crises since 2008 is helping EM investors.Furthermore, as the crisis matures the asset class return attribution andportfolio statistics are changing as well. Some of those statistics are bigenough to trigger marked investment allocation changes due to the changes
Jan
00 Jan
02 Jan
04 Jan
06 Jan
08 Jan
10Brazil IndiaRussia Indonesia
B-BB+BB-BBBB+BBB-BBBBBB+A-AA+AA-AA
Jan
00 Jan
02 Jan
04 Jan
06 Jan
08 Jan
10Portugal FranceItaly Spain
BBBB+BBB-BBBBBB+A-AA+AA-AAAAAAA+
Fig. 5: IMF Government Debt to GDP
Source: Nomura, Bloomberg
Fig. 6: EM fund flows against lagged returns shorter sample 
Source: Nomura, Bloomberg, EPFR
020406080100120140Jan-00Jan-03Jan-06Jan-09Jan-12Jan-15EM Debt %GDPDM Debt %GDP%GDPR² = 0.5188-6000-4000-2000020004000600080001000012000-10-5051015Rolling 12 week returns(1 month lag) (%)Rolling 12 week fund flows (US$mn)
 
Nomura | EM FX Insights31 January 2012 
3in riskiness of the portfolio.For instance, since the QE II was embarked by the FED, 10-year Italiangovernment bonds fell 22% in price, Spanish bonds fell 17% (both numbersexclude the currency moves). The performance for different beta countriesvary: Portugal bonds have halved in value for instance in 12 months andFrench bonds had a volatility of 10% up-and-down. These performances aretelling when compared to higher beta and (perceived) risky countries in EM.South Africa’s 10-year bond is unchanged in price for instance in price in alike-for-like comparison and it has lost only 6% in price at the most volatilemoment in global markets. Similarly, Turkey’s and Poland’s 10-year localgovernment bond were less volatile than French government bonds over thepast year. Real money benchmarks for EM bonds are up around 5% in themeantime and up 10% including currency effects.In short, we are saying that the Sharpe Ratio of EM and DM fixed incomefixed income investments started to differ quite significantly over the past 12-months and this performance will probably trigger some institutional investorsto increase their EM allocations.
Past return determines future flows
EM benchmark bond indices had one of the strongest starts to the year with a7% performance. Furthermore, they outperformed the US for the first time in awhile in recent months. Lagged rolling historical returns for EM local bonds doplot relatively well with rolling flows. This is no surprise for us given the historyof work on trending returns and asset allocations geared toward winners.Note that this link has been strengthening in time where a narrower samplefrom 2010 has a much higher R-squared (Figure 6 and 7). This may wellsignal there has been a structural break as the global crises is becomingmore-fiscally-geared towards EM. We were surprised to see, however, theoutperformance / underperformance vs. US have somewhat more mixedresults (Figure 8).
….the irony is the world has forgotten about the EM flows
The recent performance indicator of EM local and sovereign assets is tellingus that it can create a virtuous circle. When the Fed launched QE II, the worldassumed EM bond markets would get inflows in a short time, with US pensionfunds increasing their allocations to high-single digits. The fast money pilinginto EM resulted in a big positioning clear out in 2H11 and the EM bondmarkets (as well as dedicated equity funds) now seem to have all the reasonfor strength. The world, appears not ready for the forgotten theme and soon“lack of assets can become the most frequently used word again in EM circles.R157s in South Africa (seelink) and 2017s for Turkish Eurobonds (seelink  andlink) appear best placed to benefit from this theme.
Fig. 7: EM fund flows against EM bond returns
Source: Nomura, Bloomberg, EPFR
Fig. 8: EM fund flows and returns over US Treasuries
Source: Nomura, Bloomberg, EPFR
-30-20-100102030-15000-10000-5000050001000015000Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11Rolling 12 week flowsRolling 12 week EM GBI returns (rhs)(US$mn) %
-30-20-100102030-15000-10000-5000050001000015000Jan-04Jul-05Jan-07Jul-08Jan-10Jul-11Rolling 12 week flowsEM -US 12 week returns spreadUS$mnReturns Spread

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