QNB Group’s weekly report revealed that global capital flows are returning to emerging markets, driven by the continued decline in the exaggerated valuation of the US dollar and the relatively stronger economic fundamentals in most emerging market countries. In addition, institutional investors hold small positions in emerging market assets. Recent efforts to increase diversification of investments, driven by factors such as high valuations in developed markets and concerns about inflation, may lead to an erosion of the prevailing sentiment that favors US assets as the “best of all available”. Currently, institutional investors hold less than 10% of their equity portfolios in emerging markets, against a weighting of 12% in the MSCI index and the fact that 34% of all global revenue is derived from emerging markets. A meaningful change in privatization policies could lead to more global capital flowing into emerging markets.
The report added: Despite the challenges in the global macroeconomic environment, driven by factors such as rising inflation, tight monetary conditions and geopolitical frictions, emerging markets are set to benefit from some positive factors in 2023. As the year progresses, market participants are becoming increasingly aware The flexibility and opportunities offered by many emerging market economies.
According to the Institute of International Finance, there has been a significant shift in inflows from non-resident portfolios to emerging markets, which represent foreign investors’ investments in domestic public assets. After a period of negative or weak numbers throughout most of 2022, these three-month average flows have increased to more than $30 billion. These capital inflows contributed to significant gains across emerging market asset classes, including a more than 17% increase in total return on equity (MSCI Emerging Markets Index) and a 14% increase in bond yield (JPMorgan Emerging Markets Global Bond Index). from recent lows.
In a challenging global environment, what drives optimism about some emerging markets? From our point of view, there are two main factors that explain the positive backdrop for emerging markets, which are the decline in overvaluation of the US dollar, and the presence of strong macroeconomic fundamentals in most emerging markets compared to developed economies.
First, the overvaluation of the US dollar is easing, which is providing a strong windfall for emerging market assets. As a traditional safe haven, the US dollar is inversely correlated to most “risk-taking” assets, including emerging market stocks and bonds, which carry a greater amount of risk than similar assets in more stable and advanced economies.
The value of the US dollar has already fallen by nearly 5% against major emerging market currencies since late last year. It should be noted that although the strength of the US dollar has moderated in recent months, the US dollar’s real effective exchange rate – which is the trade-weighted, inflation-adjusted foreign exchange rate – still indicates a 15% appreciation of the US dollar over its long-term trend. The real effective exchange rate is often used to determine the “fair value” of different currencies, as it explains changes in trade patterns between countries as well as economic imbalances represented by inflation and its differences.
The deviation of the real effective exchange rate from the long-run average
The report shows that additional adjustments to the US dollar during the coming quarters are likely to push capital outside the United States towards other economies, as the decline in the value of the US dollar is appropriate for diversified global portfolios. This situation would be particularly beneficial to developed economies with undervalued currencies, such as Japan, Canada, the United Kingdom, the Eurozone and Australia. However, emerging markets with undervalued floating currencies are also expected to benefit, including South Africa and Brazil. In fact, the general diversification away from the US dollar is expected to support all countries, including other emerging markets.
Second, macroeconomic fundamentals are currently stronger in most emerging markets than in advanced economies. Many advanced economies experienced severe imbalances from excessive stimulus policies in the aftermath of the pandemic and the Russo-Ukrainian war, which led to problems such as high public debt and inflationary pressures. The reason for this was the need to protect household and corporate income from large negative shocks.
In contrast, most emerging market countries had less room to use economic policy to adjust to the shock of the pandemic. Moreover, central banks in emerging market countries with a history of chronic inflation, such as Brazil and Mexico, have faced pressure to implement interest rate increases proactively early in the inflation cycle. This proactive approach was crucial in keeping inflation in check and maintaining macroeconomic stability.
As a result, emerging market countries are now under less pressure to tighten, and may even begin early easing cycles, as their economies have largely adjusted to less benign global conditions.
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