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Since tapering ended, investors have generally turned away from risky assets and towards safer ones. After noting the inflows and outflows in the main asset classes in 2015, we will focus in particular on emerging markets inflows and shifts by Gulf sovereign-wealth funds, which are raising many questions. As for 2016, while drawing a distinction between “taper tantrum” effects – which will most likely recede if the Fed stays on a cautious footing – and the emerging market slowdown, flows are likely to be very cautious, as long as doubts on China and oil prices have not been resolved.
Pulling out of the riskiest asset classes
Throughout 2015, the markets were increasingly on high alert, resulting in outflows from the riskiest assets – including emerging assets, equities and US high yield bonds – and a return to the safest investments, such as sovereign bonds issued in developed economies.
This quest for safe havens has accelerated since tapering ended in autumn 2014 (see chart 1). As a result, from the start of November 2014 to the end of January 2016, a net USD 131bn flowed out of US equities, while, at the same time, almost USD 112bn flowed into US bonds. Similarly, a net USD 23bn flowed out of the riskiest corporate bonds (high yield), while USD 33bn flowed into safer investment grade bonds. And a net USD 95bn and USD 34bn, respectively, flowed out of emerging equities and bonds, both of which are considered risky. Ultimately, amidst this across-the-board rush back into quality, only Japanese and European equities – both driven by very active central banks – stood out, with USD 66bn and USD 119bn, respectively, flowing in over the same period of time (see chart 2).
By sector, outflows from overcapacity-burdened emerging equities resulted in weaker inflows into industry, infrastructure and basic materials, as well as utilities, as power generators were hit indirectly by falling energy prices. In contrast, market participants poured into defensive sectors like healthcare and telecoms, but also, more surprisingly, energy, where the profiles of publicly listed majors ultimately brought on some bargain hunting (see chart 3).
Inflows into emerging markets being squeezed
Financial inflows into emerging markets collapsed in 2015, driven by China’s difficulties, falling commodity prices and the prospect of Fed rate hikes. Various approaches, from the broadest to the narrowest, point to the impact of this infamous taper tantrum.
Based on the broadest definition of the balance of payments1, in 2015, no less than USD 736bn flowed out of emerging markets, according to the Institute of International Finance (IIF), vs. USD 111bn in outflows in 2014 (see table). At the nadir of the 2008-2009 financial crisis or the 1998 Asian crisis, money continued to flow into emerging markets. So these are unprecedented amounts since these statistics began to be kept in 1978 (see chart 4).
Similarly, and also according to the IIF, when the balance of payments approach is narrowed to mere net portfolio flows (i.e., when excluding current account and foreign direct investment) into or out of emerging markets, these dropped by an estimated 86%, to USD 41bn in 2015 from USD 301bn in 2014.
And, lastly, based on the EPFR database, which measures mutual fund inflows and outflows, a combined USD 99bn flowed out of emerging equities and bonds, vs. USD 25bn the previous year. While the methodologies and, hence, the outcomes, differ from one approach to another (see box), the conclusions are the same: financial inflows into emerging markets shrank drastically.
This is due above all to China (USD -676bn in 2015 out of a total of USD -736bn; see table), which, among other things, had to defend the yuan and cope with early repayment of local USD-denominated debt, following fears of new devaluations. Be that as it may, other emerging economies also suffered an increase in net outflows (from USD -11bn in 2014 to USD -60bn in 2015), driven by a weakening in their growth prospects and solvency. While this drop was especially serious in inflows from non-residents, which dropped 43%, from USD 700bn in 2014 to USD 401bn, in 2015, outflows from residents fell by 35% from their 2014 peak, due to the outbreak of the Russian-Ukrainian crisis.
Selling pressure from Golf sovereign-wealth funds expected to continue
Falling oil prices led Gulf sovereign-wealth funds to sell an estimated 8% of their assets in 2015. With almost USD 2800bn under management, these sovereign-wealth funds sold an estimated USD 185bn to USD 250bn in 2015, based on various estimates from JP Morgan and the IMF, i.e., 7% to 9% of their assets.
As these countries’ budgets are generally in balance only when oil is above $80/bbl., the selling pressure from sovereign-wealth funds is unlikely to lessen in the coming years, even if oil prices were to rally.
Selling pressure is expected to be especially heavy in equities. According to State Street, the portfolios of Gulf sovereign-wealth funds are composed mainly of bonds (43% of the total) and equities (38%). The rest is in less liquid diversification assets (19%) such as private equity, real estate and infrastructure. Given the lack of liquidity of diversification assets and the protection offered by sovereign bonds ( Treasuries, Bunds, etc.), prices of which generally move in the opposite direction from oil prices, outflows are highly likely to be mainly from equity portfolios.
Flows remain on a cautious footing in 2016
During the first weeks of the year the financial markets were once again roiled by new lows in oil prices and a further depreciation in the Chinese currency. In turn, these events exacerbated outflows from the riskiest assets and the quest for safe havens. As a result, according to EPFR, from 1 January to 24 February 2016, US equities and emerging equities and bonds suffered overall outflows of USD 67bn. In contrast, US Treasuries, German Bunds, and money- market products received inflows that were almost equivalent, at USD 70bn.
However, regarding more specifically net inflows into emerging market portfolios, there was glint of hope from the Institute of International Finance, which, after seven consecutive down months, reported a virtual return to equilibrium in February (see chart 5).
Yes, one isolated statistic doesn’t make a trend but if this glint of hope is confirmed, it would corroborate the IIF’s forecasts from early this year that net outflows from emerging economies would recede by almost 40%, to USD -448bn in 2016 vs. USD -736bn last year. All told, for this improvement to stay on track three conditions are necessary: for Fed policy to remain gradual and therefore not surprise the markets; for oil prices to begin to stabilise and then rise slightly; and for China to manage to reassure investors that its economy and exchange rate policy have been shored up. While the first two conditions look within reach, China should continue to cast a long shadow over the markets for several more months. In the meantime, these risky assets’ performances and flows are likely to remain volatile, leading to alternating cycles of fear and hope.
1 Balance of the capital account, adjusted for changes in reserves, errors and omissions.
Apart from Japanese and European equities, outflows from risky assets has been the rule since tapering ended
The first signs of stabilisation in emerging market flows, but the resulting lull remains to be confirmed
Uncertainty in financial markets makes portfolio diversification a valuable tool to navigate difficult market conditions. Diversification is probably the only free lunch in finance. It is closely related to asset segmentation: different representations of portfolio diversification are derived depending on what is considered the atom of asset allocation (capital / risk / factor). Probably a single measurement cannot provide a comprehensive representation.
Quantitative research at Amundi
This paper addresses management of sovereign wealth from the perspective of the theory of contingent claims. Starting with the sovereign’s balance sheet, we frame sovereign fund management as an asset-liability management (ALM) problem, covering all public entities and taking explicit account of all sources of risks affecting government resources and expenditures. Real-life SWFs asset allocations differ strongly from theoretical ones. Financial management of the sovereign balance sheet is hampered by a lack of aggregate data, which compromises the coordination of sovereign wealth management with fiscal policy, monetary policy and public debt management. In this framework, we suggest institutional arrangements that could overcome this obstacle and enable efficient coordination.
Zvi BODIE, Marie BRIERE