The IIF’s Guarded Capital Flow Gaming

Despite declaring mutual fund investors “back in the game” as the retail portion in particular remains below the historic average, the IIF’s mid-year 30 country capital flow reading pared this year’s allocation $50 billion to $1.1 trillion on sweeping Russia-Ukraine and China tensions. In the first half bank lending was running at only half 2013’s pace while Europe’s take was down 25 percent. Equities have picked up on positive MSCI performance, while corporate debt is a fixed-income worry and FDI is steady at $650 billion. China is still the leading destination but regional slack there will be offset by portfolio investment increases in India and Korea. Since the Fed taper scare which uniformly battered currencies they have since been less correlated even as GDP growth and business confidence have not improved, as risk appetite measured by the VIX and global monetary policy are “supportive,” the survey comments. Of the original “fragile five” Turkey and South Africa continue with large current account deficits and above-target inflation. Downside scenarios include a reversion to normal benchmark spreads as reflected in the US corporate BBB margin over Treasuries, and industrial world central bank liquidity withdrawal, or renewed convergence of developed and developing country stock valuations. Their forward P/E ratios are now respectively at 14 and 10, and differences within the main EM universe seem to be justified by underlying economic expansion, with Brazil trading 10 times below the Philippines for example, according to the group. However it notes that price to book values have fallen sharply the past five years due to increased leverage in major markets like China, Hungary and Korea as average corporate debt/GDP rose from 55 percent to 80 percent. Although an established asset class with the size of JP Morgan’s CEMBI at $825 billion, vulnerabilities have “raised concern” and through June non-financial issuance especially has been off 50 percent. Sovereign bonds in comparison have been up 25 percent, and for the combined categories 60 percent has been in local currency. Equity placement at over $50 billion has also lagged 2013’s pace, with $15 billion of the sum through 125 IPOs, despite the $850 billion in tracked international fund holdings.

In China resident capital outflows of $600 billion will be 50 percent above inflows, as currency depreciation discourages the carry trade. India and Indonesia could enjoy post-election surges, while Thailand’s political crisis could be “prolonged.” Central Europe’s five EU members have been relatively unaffected by the Russia-Ukraine and Turkey troubles but flight could hit Hungary and Poland with their 30 percent foreign investor bond ownership. Latin America is second most popular with $260 billion predicted as domestic debt has become the major attraction in Mexico and Brazil as well as in mid-size Colombia and Peru. In the Middle East Egypt, Lebanon and Morocco could gain with FDI and fund repatriation on transition progress, while in South Africa $2.5 billion in portfolios have been “rebuilt” after the central bank raised rates and second-term President Zuma raised hopes of cabinet and policy switches.