Emerging markets pushed to the sidelines for now

Emerging markets have become a victim of China's success in 2020, with money managers and investors now underweight and pulling assets from equity and debt allocations as they watch and wait for better times to resume.

The recovery in the U.S. dollar, an increase in safe-haven asset yields in the first quarter and China's tighter monetary policy have contributed to the underperformance of emerging market assets vs. developed market assets so far in 2021.

On top of that, developed markets continue to ride the vaccine- and stimulus-induced wave of positive performance, marking these regions' recoveries and setting them further apart from emerging markets.

Emerging markets equity funds tracked by data provider EPFR ended the second quarter of 2021 with a three-week run of outflows. For the second quarter, net inflows dropped to $15.9 billion, following $68.4 billion in net inflows for the first quarter of 2021 and $44 billion in net inflows for the fourth quarter of 2020, according to EPFR.

As of June 25, emerging markets bond funds saw an 11-week run of inflows come to an end as they posted their biggest weekly outflow since early March, according to EPFR. Figures were not available. At the end of the second quarter, investors had pumped $13 billion in net inflows to emerging markets bonds funds. That followed $11 billion in net inflows in the first quarter of 2021 and $45 billion in net inflows in the fourth quarter of last year.

While investors sought more exposure to risky assets, including emerging markets, in the second half of last year and the first quarter of this year, they have gradually dialed down their appetites in the second quarter of this year. Both investors and fund managers moved to reduce their exposure to emerging markets due to fears that tighter Chinese monetary policy will hit the country's growth and its demand for other emerging markets' commodities exports, EPFR said.

In the first half of 2021, the MSCI Emerging Markets index delivered a performance of 7.5%, below the 13% recorded by the MSCI World index over the same period. The Emerging Market Bond Index Global Diversified returned -0.72% year to date as of July 6, while the local currency Government Bond Index-Emerging Markets Global Diversified returned -4.19% for the same period.

Investors said they are now waiting for more signals that emerging markets will do better before they will move to an overweight position.

Luc Vanbriel, Brussels-based CIO of the €2.5 billion ($3 billion) Pensioenfonds KBC, said in a telephone interview that the fund is slightly and temporarily underweight its tactical allocation to emerging market equities, which accounts for 10% of its overall equity allocation. The fund's total equity allocation was not available. Similarly, the fund has been reducing its tactical exposure to emerging market bonds to a fifth of its total bond allocation of 18.5%. "We are positive on listed equities, underweight emerging markets because we are overweight eurozone equities," he said. "We keep on assessing the situation. Emerging markets still have to recover more than North America and Europe. It might be that in six to 12 months we are overweighting emerging markets," he said. "China has outperformed in 2020. The rest of emerging markets were slightly underperforming but they will catch up. They have high growth rates and that's the reason why we want to be in emerging markets," he said.

State Super, Sydney, is currently underweight emerging market equity in its A$8 billion ($6.1 billion) defined contribution portfolio and neutral in its A$34 billion defined benefit portfolio. CIO Charles Wu said the allocation in the DC portfolio is at about 7% — under the fund's strategic allocation of 9%.

"We are not increasing emerging equity exposure. At this stage, we have preferred to take risk in developed markets. We are now dealing with infrastructure-type questions — for example, if there is enough capacity to respond to COVID-19 outbreaks," he said in a telephone interview, referring to concerns over emerging markets' preparedness for coronavirus variants. "There are other places where the capital can be channeled," he said.

Other sources said that emerging markets had benefited from inflows to risky assets in the second part of last year. The weakening of the dollar, which had benefited the valuation of emerging markets assets throughout 2020, reversed in the first quarter, Frank Smudde, expert portfolio manager asset allocation at APG Asset Management, said in a telephone interview. APG is the in-house manager of the €495.3 billion ABP, Heerlen, Netherlands.

Mr. Smudde said that on a tactical level his firm lowered its emerging market equities allocation in the first quarter of this year on the back of China tightening its monetary policy and the dollar's appreciation, but he didn't disclose the size of the reduction. APG's target allocation is for about 7% of its equity and 5% of its total assets to be invested in emerging markets.

The U.S. dollar index fell 0.74% as of July 8 vs. March 31 and was down 4% vs. July 8, 2020. The dollar, which appreciated in the first quarter of the year as interest rates increased, negatively impacted emerging market asset prices, sources said.

APG's Mr. Smudde added that in the second quarter U.S. rates didn't increase as much as in the first quarter and there has been a moderate dollar appreciation, lifting pressure off emerging market investors.

Other sources agreed that macroeconomic conditions in the second half of the year are set to change course and could in turn prompt investors to reconsider their emerging market exposures in the next six to 12 months. That's because of improving fundamentals in emerging market economies and an approved $650 billion in support from the International Monetary Fund providing financing to mitigate the impacts of the pandemic. Even tapering from the U.S. Federal Reserve is expected to be well-telegraphed and will not have a big impact on investors' decisions to invest in emerging markets.

Gustavo Medeiros, London-based deputy head of research at Ashmore Group PLC, said in a telephone interview that there is a big chance that a new spending bill will be passed in the U.S. in September. That would keep the Fed behind the curve, meaning it won't increase interest rates fast enough to keep up with inflation increases. "I think this environment is actually very supportive for EM asset prices, in particular, considering the vaccine convergence that allows for the economic bounce back that we saw in the second quarter in the U.S.," he said, adding that the economic rebound is next likely to come to Europe and later to emerging markets.

Mr. Medeiros added that vaccination rates aren't as high in emerging markets as in developed markets. "Many (EM) countries are not out of the woods (yet)," he said.

From APG's Mr. Smudde's point of view, "Investors have come to terms that China is tightening. A further spread of the coronavirus and delta variant taking hold in India, Indonesia, Malaysia and Brazil (could mean) there is some danger that lockdown measures will take a toll later. We have to take that into consideration," he said.

To become excited about emerging markets again, and particularly to boost APG's emerging market debt allocation, Mr. Smudde said he wants to see the COVID-19 pandemic resolved and serious efforts toward vaccination in emerging markets. Another "game changer" for Mr. Smudde would be the change of economic stance by the Chinese government to looser monetary policy — although that will not happen before the Fed starts tapering.

Still, Mr. Smudde said: "If (the) Fed is going to taper, we will see rising rates across the whole curve in the U.S. and as risk-free rates rise the search for yield will not be as intense as it used to be ... You could expect that if monetary policy is less intense you would see spreads drift back up a little bit," referring to spreads between emerging market debt and U.S. Treasuries.

Kristoffer Fabricius Birch, head of equities at LD Pensions in Frederiksberg, Denmark, said the fund is sticking to its neutral allocation to equity emerging markets for now. "From a tactical perspective, we haven't been able to identify drivers that would (let) us take a tactical decision (about investing more in) emerging markets," he said. But he said that an entry point to emerging markets could be if a global reflation trade were to reappear. "I guess that happened in the last part of last year, but I am a little bit confused to why it hasn't been the case lately. U.S. interest rates have fallen since March and the reflation trade globally has faded out. I would think a point of entry would be if the reflation trade reemerges. That would be one scenario," he said. LD Pensions invests about 13% of its 14 billion Danish kroner ($2.2 billion) equity allocation in emerging markets. The fund has 55 billion Danish kroner in assets.