In addition, sentiment has been hijacked by a whole series of risks including debt problems in peripheral Europe, the potential for a hard landing in China and rising concern about the need for US fiscal consolidation.
This has increased uncertainty and reduced the conviction of market participants, in turn feeding back into heightened volatility with investors less prepared to hold positions and stick with views. Sentiment continues to turn with alarming frequency and speed on precious little change in the underlying fundamentals.
Indeed, the so-called risk on/risk off paradigm has been central to the way the market has behaved. Despite our view that the second half of the year will have notable differences from the first half this characteristic seems set to continue through year end.
In all this volatility, developed world stocks have outperformed emerging markets so far this year as fund flows have favoured developed relative to emerging markets. In our view, this out-performance of DM versus EM should be seen as a one-off rotation – the result of investors re-pricing an improved view of the sustainability of developed market growth and shifting portfolios accordingly.
First half rotation
According to data compiled by EPFR, net outflows (including market valuation changes) from emerging market funds during the first half of the year exceeded $12.8bn (1.4% of assets under management) whereas net inflows (calculated on the same basis) to developed market funds over the same period were $42.7bn, equivalent to 0.6% of AUM.
Within these totals the biggest proportional emerging market outflow was from Latin American funds (close to $4bn, or 5.1% of AUM) followed by Asia ex-Japan funds ($7.3bn, equivalent to 2.3% of AUM.)
Bucking the trend, EMEA net fund flows (including valuation changes) were actually positive ($1.3bn, equivalent to 2.3% of AUM) although there was a sharp divergence between the Middle East and Africa (net outflows equivalent to more than 10% of AUM) and Russia where net inflows represented some 17% of AUM.
In terms of the developed markets, Japan was the best performer from a flow perspective, registering net inflows of almost $D2bn, equivalent to 3.7% of AUM. Net flows into US funds totalled almost $11bn over this period and, perhaps surprisingly, flows into west European funds were slightly positive (0.6% of AUM.)
Can EM recover lost ground in the H2?
We believe that 2011 will prove to be a year of two halves. The increasing realisation on the part of the investor community of the necessity for deleveraging in the developed world and the negative consequences for companies focused on demand there is likely to re-balance investor sentiment from developed to emerging equity markets.
The positive trends are likely to come out of the emerging world. As the implications of excessive leverage in the developed world become clearer – an overall drag on developed world growth and corporate profitability – we believe that net underlying flows will shift back to EM helping these markets outperform developed markets in the course of the second half.
In contrast to the developed world, we generally remain upbeat about EM growth prospects and inflation concerns are likely to start to ease on the back of recent more aggressive tightening from the likes of India and China. Having corrected from their highs earlier in the year, on many standard valuation metrics, emerging markets equities now offer value – the Shanghai Composite, for example, has fallen by more than 11% from this year’s mid-April high on concern that higher interest rates will curb growth and depress corporate earnings. In fact, the BRIC markets are all now trading cheap to their five-year average valuations (Brazil is trading on 9.5x 2011 earnings vs. to a 5 year average of 10.1x; China is on 10.8x vs. 13.5x; India 15.4x vs. 16.1x and Russia just 6.3x vs. 8.2x.)
Through the end of the summer markets are likely to continue to be burdened by an overhang of risks and poor liquidity – the normal consequence of summer in the northern hemisphere. But come the autumn, markets should settle down as liquidity returns and it becomes clearer that global recovery remains on track. In such an environment emerging equity markets are likely to outperform.
