Capital flows into emerging markets suggest that valuations could be about to end their two-year slumber, argues Michael J Howell

The year 2013 could be the start of another great period in emerging markets (EM) –one that may echo the strong gains enjoyed in the mid-2000s. Money always moves markets, but the impact of cross-border flows on EMs is often dramatic and not always well-understood.

Our research work has previously warned that EM experienced large outflows in the uncertain period between the end of the US Fed’s QE2 policy in 2011 and the announcement in mid-September 2012 of the start of QE3. Not surprisingly, many EMs suffered and former stars like China and Brazil saw their stock market indices skid lower. Indeed, amid this gloom, our internal measures of investor exposure suggest that portfolio weightings to EM are now two standard deviations below their three-year trends. As good contrarians, you should be already smacking your lips.

But there are more and bigger facts to chew on. First, in the period since early 2011, there has been a sharp and sustained monetary tightening by many EM central banks, led by the Peoples’ Bank of China (PBoC). Is this big squeeze ending at last? Second, our measures of cross-border capital flows have lately swung from red to black. In short, the former whopping capital outflows from EM are turning into life-sustaining net capital inflows.

What’s more, many EM investors are putting their cash where their mouths are. The largest investors in these markets are not US retail investors buying mutual funds, but large, high-net-worth investors from the EMs themselves.

When domestic times get tough, these super-rich often, literally, up anchor and get going. Thus, wealthy Turks, Brazilians, Chinese and Russians frequently switch their offshore investment holdings between their home markets and sometimes safer Western banks. But they also tend to be among the first to spot emerging value in their own countries. The cynic in us concludes that these footloose ‘safe haven’ funds may quickly drain away from the West, so causing US bonds to spike and Notting Hill and Mayfair property prices to crash as the flows reverse in 2013.

On top, the QE3 money machine will embrace far more economies than America and Europe. It is clear from our analysis that China’s PBoC began turning its money tap back on from May 2012. This trickle is turning into a serious flow. Other EM economies are also starting to follow suit.

It is also important to distinguish the differences between QE3 and the preceding QE1 and QE2 liquidity injections. Policy-makers’ focus up to now has been on restoring the health and integrity of their banking systems: the US Fed led the way and the ECB followed some two years later. Latest endeavours enshrined in QE3 are now about restoring economic growth and cutting unemployment queues. If their former actions revived bank share prices, then the planned QE3 should prove a welcome shot in the arm for cyclical shares and commodity prices. Watch EMs move up.

This cash will, as always, spill over directly into EM stock markets. During QE1 and QE2, capital inflows into EM jumped significantly. Contrariwise, in the lulls after these QE injections ended, sizeable volumes of foreign capital exited. These are classic ‘risk-on’ and ‘risk-off’ moves showing just how pro-cyclical EM can be. The figure shows the pattern of net inflows into EM using a nine-month moving average of aggregate US dollar net financial flows. Already this measure is inching higher in anticipation.

This foreign money also acts as an accelerator. Note that our two key drivers of EM are central bank actions and foreign money flows. The exciting fact is that the two are closely connected since more foreign money typically forces domestic policy-makers to ease. This is often a defining feature of EM and it is explained through both policy decisions to fix exchange rates to a major currency, such as the US dollar or, more generally, because by definition EMs are also ‘emerging financial markets’ and many do not as yet possess deep and sufficiently liquid domestic asset markets that allow independent management by central banks.

Put in technical terms, foreign exchange reserve holdings often dominate movements in EM monetary bases. Therefore, changes in forex holdings can sometimes be a useful lead indicator of EM liquidity. These, too, are bottoming out. Capital is coming back: After two years stuck in the doldrums, emerging stock markets are set to melt up.

Michael J Howell is managing director at CrossBorder Capital