Key Highlights

• Emerging market equities are significantly underheld, setting them up for a bounce as risk aversion and growth concerns wane
• The current macro environment, with hopes for a Ukraine/Russia peace deal, bolster Poland, while lower energy costs and trade deal hopes help India as tariffs hit China
• Fiscal constraints, continued USD dependence and links to U.S. rates keep EM investors wary of buying value

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Which way for emerging market equities in May?

EXHIBIT #1: APRIL EM MARKET EQUITY AND FIXED INCOME FLOWS

_{Source: BNY iFlow}

April was cruel to most markets but particularly emerging markets. Risk aversion hit carry trades in FX, with most of money flows the result of selling fixed income to bring money back home. A few countries also saw significant outflows in equities, including China, Brazil and the Philippines. A return of risk appetite for EM investments will require clarity about tariffs and rates. The link between extremely negative carry conditions and equities in emerging markets highlights the medium-term risk of fiscal dominance. There is increasing doubt that the current global slowdown will be offset by fiscal stimulus as it was during the Covid crisis. The response to tariffs also has a limit on FX as too weak a currency prevents monetary policy accommodation. Exhibit #1 shows combined fixed income and equity flows, highlighting the current stalemate for investors.

Our Take 

The flow of money out of emerging markets was significant in April. U.S. tariff policy announcements led to a large unwinding of carry trades and a reversal in China equities. In Q1, Chinese AI surprises and small levies on trade from the U.S. helped investors return to benchmark holding levels. This trend has reversed sharply. The ability of global investors to access emerging market opportunities is limited, with sovereign and corporate bond markets being the largest pool, followed by equities. The role of private credit and equities has been on the rise but remains limited. Overall, EM indices are dominated by bonds rather than equities.

Forward Look 

The speed with which India pushed for a trade deal with the U.S. in April shifted the focus for many emerging market investors to that nation and any countries well connected to it. India benefits from cheaper energy prices, and the 18% drop in oil prices has been an important tailwind for its manufacturing sector. Investors in India saw a modest bounce back in equity flows in April, while bonds have been sold modestly because of FX and budget worries against the Reserve Bank of India’s (RBI) clear easing push. India’s growth potential also plays well in the longer term due to demographics. For the rest of emerging markets how they interact with and compare to India becomes a benchmark.

EM equities, by sector, show consumer stables, financials, and energy recovery

EXHIBIT #2: EXCESS EQUITY FLOWS

_{Source: BNY iFlow}

Our Take 

EM equity flows in the last month and quarter were negative except for consumer staples. This reflects an inherent concern about valuations, global growth and the overall risk appetite of global investors. The spike in the last two weeks of April highlights the view that energy prices have bottomed out, with oil below $60bbl pushing the decline to over 25% y/y. Consensus flows in buying banks and real estate highlights the hope that rate policy will support those sectors.

Forward Look 

Global flows into EM equities are constrained by USD and rate policy – with hopes of FOMC easing high – 1% cuts are fully priced. This means that recoveries in EM remain linked to how slow the U.S. growth rate proves to be in the next quarter. There is a window for EM outperformance if central bankers have room to ease and governments have room to spur new spending without hitting their own bond markets. This is the current stalemate as investors clearly want to invest in domestic rather than in international growth sectors in EM.

EM has value and growth potential if global risk aversion reverses

EXHIBIT #3: EM EQUITIES CROSS-BORDER FLOWS AND HOLDINGS ARE NEAR HISTORIC LOWS

_{Source: BNY iFlow}

Our Take 

April selling in EM equities was extreme but not dissimilar to the Q4 December washout linked to Europe and China growth concerns. The bigger surprise in EM equities has been the lack of buying in the first quarter. Some of this reflects the constraints of central bankers to ease further, but much is driven by value and geopolitics. Holdings in EM are back to 2016 lows. Even the ex-China flow reveals near historic lows for holding EM equities. Volumes in EM market volumes peaked in Q4, reflecting a washout trade linked to the FOMC policy shift from easing to pausing.

Forward Look

Investors have an opportunity to find value in EM with a rare chance of diversity. LatAm enjoyed a better outcome in Q1, and many see EMEA leading in Q2, while APAC is focused on India. There is also an opportunity in the value metric of EM as the average P/E there is 14.9 compared to 25 in the U.S. and 17.1 in the EU. The longer-term story for investors mixes good policy with positive demographics along with the current tactical points about value. Convergence of value metrics across developed and emerging markets can still occur in a world more focused on national interests rather than globalization. The criteria for success in EM investments will start with policy pushes that build on sustainable domestic demand rather than on export-focused strategies. Extraction economics and cheap labor are no longer sufficient tools to attract investors.

Bottom line

In the short term, investors are likely to see EM stocks as a value play and as a diversification against current U.S./China tariff risks. The role of MSCI EM Ex-China as a benchmark is on the rise. Much of this remains an Asia-focused list heavily skewed toward financials and technology. There is room for investors to consider more domestic focused companies providing consumer staples, financial services and real estate. Those flows have been notable in the last few days and will be a trend to watch for the next few months. The bigger picture remains one about global growth, political risks and how uncorrelated EM is in to the developed world. For many, the fragmentation of global supply chains opens up new opportunities, and EM is the most obvious one.

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