EMs are important to the global economy, representing a 35 percent share in current dollars and 60 percent based on purchasing power parity, according to IMF estimates. Their presence in global equity indexes is far smaller, at 12 percent of the MSCI All-Country World Index currently. And many investor portfolios fall well below that: BlackRock analysis of U.S. advisor allocations shows total portfolio exposure to EM equities at just 3.5 percent as of September. But investors seem to be warming up. Net flows into EM equity funds are on track to reach $70 billion this year, or about 6 percent of assets under management (AUM), as illustrated In the Only just begun chart above. This is a solid reversal from the $114 billion in outflows over the last four years (amounting to 14 percent of AUM). And yet fund flows and price momentum are not signaling mania, research from BlackRock’s Risk and Quantitative Analysis team shows.
EM equity and debt flows have benefited from easy monetary policy in what has been a prolonged investor search for yield. Nearly 50 percent of EM portfolio inflows are a result of Fed actions and quantitative easing (QE), based on IMF estimates. QE has depressed DM yields, making relatively high EM yields an attractive proposition. Equally noteworthy are flows within EM. Equity flows from mainland China to Hong Kong now account for 10 percent of daily exchange volume and roughly 50 percent of global EM net inflows year-to-date, based on data from Wind Info.
What are the risks? The Fed's move to stop reinvesting maturing bond holdings reduces global QE. The IMF estimates 30 percent of the flows into EM since 2010 due explicitly to U.S. monetary policy could reverse over the next 24 months. That may not fully capture the effect of improved global growth, however. A rapidly strengthening U.S. dollar would be a related risk, as it has often proved in the past. We only see the dollar appreciating gradually, however, and expect limited impact on most EMs. The majority have stronger current accounts and reserves than during 2013's "taper tantrum." Other risks? A stronger-than-expected slowdown in China, potential for tense trade relations, and elections and populist politics undermining reform agendas. All of these risks are real but do not overpower what we see as a solid investment case for EM equities.
Kate Moore is chief equity strategist for BlackRock.