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Emerging markets bleed capital again; investors say now's the time to buy

International investors have jettisoned their holdings of emerging market stocks and bonds of late but some analysts and money managers are betting that EM could be poised for a comeback.

Sentiment has been particularly dour in the second quarter this year with June showing $8 billion in net outflows from the asset class, after $12.3 billion of outflows in May, a survey from the Institute of International Finance showed Tuesday.

Brandywine Global Fixed Income Portfolio Manager Jack McIntyre on the market and consumer impact from trade uncertainties and Federal Reserve policy.

It was the first time the asset class has shown outflows for two straight months in debt and equities since the great financial crisis in 2008. The second quarter was also the weakest for EM since the fourth quarter of 2016.

After a high-flying couple years, emerging markets appear to be stuck. Not only was June the second month of negative flows, but it marked the fifth consecutive month that flows fell below the 2010-2014 monthly average, IIF found. In fact, inflows have only topped the 2010-2014 monthly average once in the last 12 months. Also notable was that outflows came from Chinese securities, which the organization said was likely prompted by the growing trade tensions between China and the United States.

The flow of investor capital to both emerging markets’ stocks and bonds have been negative for the first time since 2008, the Institute of International Finance said.

The month began with a remarkable ‘buy the dip’ surge episode as investors scooped up cheaper EM assets, followed by an equally striking reversal coinciding with increased trade tensions and a stronger [U.S. dollar] following the Fed’s rate hike in mid-June,” IIF’s Deputy Director Emre Tiftik, Senior Analyst Scott Farnham and Senior Director Sonja Gibbs wrote in the report.

“Trade tensions, coupled with diverging economic outlooks, have also prompted a marked upturn in portfolio allocations to U.S. assets – at the expense of other developed markets as well as EMs.”

‘It’s time to buy, not sell’

This may simply be the dark before the dawn, some analysts say, as many emerging market countries boast improved current account balances, limited external debt and are still supported by a growing China and high commodities prices.

“The global growth picture is still supportive, even though it doesn’t feel like it,” said Josephine Shea, emerging markets debt senior portfolio manager at Standish Mellon, a subsidiary of BNY Mellon. “At a certain point we believe things should stabilize and the growth we’re seeing should start to come through again.”

Analysts Chris Brightman, Michele Mazzoleni and Jonathan Treussard of Research Affiliates assert that throughout EM there are “only a few small markets at any material risk of crisis.” They advise that in emerging markets, “it’s time to buy, not sell.”

This chart from Research Affiliates shows the downward trend of global poverty and inflation.

Having learned a lesson from the taper tantrum of 2013, many emerging countries have limited their holdings of dollar-denominated debt and reduced their deficits, making them less exposed to increases in the value of the dollar. Many have also increased their dollar reserves, making them more resilient to increases in the value of the dollar.

So far, though, countries such as Brazil, Taiwan and Mexico that have cleaned their proverbial fiscal house have tumbled in the emerging market selloff along with countries like Turkey and Argentina that have shown less discipline. Shea and others believe that has created opportunity for selective managers.

Two out of three isn’t bad

“There is a lot of dislocation,” Shea said, noting that prices for bonds issued by Turkey have fallen to nearly the same rate as those issued by Mongolia, which has a notably lower credit rating.

She also points out that of the three main drivers of emerging markets – growth in China, the value of the U.S. dollar and Treasury yields, and commodities prices – two are in good position for the asset class, even with the dollar’s recent strength.

Jim Paulsen, chief investment strategist at the Leuthold Group, believes that once sentiment turns and investors are again ready to move into risky assets emerging markets will again outperform developed markets. 

He says fund managers should look at paring back their holdings of FAANG stocks in the U.S., this year’s top performers, and consider moving into EM.

“I love the fact that there’s some panic to EM right now,” Paulsen said. “It tells me people are giving it away without a lot of thought.”

In an email to Yahoo Finance, IIF’s Tiftik said that indeed emerging market “valuations and allocations look attractive and this could prompt some investors, particularly dip-buyers, to enter EMs, but much will depend on how the global trade landscape and the [dollar] evolve.”

However, Win Thin, global head of emerging market currency strategy at Brown Brothers Harriman, doesn’t see a turn happening any time soon. 

“I think it’s naïve to think that the worst is over,” he said. “If anything, the trade backdrop has gotten worse. You can quibble about the Fed [raising rates], but this whole trade war is turning out to be the biggest risk for EMs and I don’t think that’s going away.”

Dion Rabouin is a markets reporter for Yahoo Finance. Follow him on Twitter: @DionRabouin.

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