Macro Insights Weekly: Unwinding of correlated trades


Unlike global trade, which is bottoming out, global capital flows to emerging markets returned a few months ago, but remain at an underwhelming level.
Taimur Baig, Ma Tieying07 Sep 2020
  • After sharp withdrawals in February/March, capital inflows to EM returned during April-August
  • On the equity side, China (USD9.2bn) and India (USD11.7bn) have garnered sizeable inflows
  • On the debt side, key recipients have been China, Indonesia, Malaysia, and South Korea
  • Overall, the movement of debt and equity flows have been largely (and positively) correlated…
  • … but lately the correlation has reversed signs (in favour of debt)
Photo credit: Unsplash


Chart of the Week: Capital flows to EM

After sharp withdrawals in February/March, amounting to USD83bn, capital inflows to emerging markets, both equity and debt, returned to some extent during April-August (USD63bn). On the equity side, China (USD9.2bn) and India (USD11.7bn) have garnered sizeable inflows. In recent weeks, equity flows have weakened while bonds have remained supported.



Commentary: Unwinding of correlated trades

Global trade is bottoming out. Despite pockets of pandemic resurgence around the world, agriculture, construction, and manufacturing appear to be on surer footing with the easing of lockdowns, boosting confidence of businesses, which is apparent in PMI survey readings. Our GDP-weighted composite PMI for Asia has rebounded handsomely, going past the expansion line of 50 in August.



While trade signals are clear, they are fuzzier with respect to capital markets. Historically low rates have made debt issuance easy and equity valuations frothy; global investors appear selective, favouring growth (particularly tech) over value, DM over EM, and deflationary over inflationary trades.

Global capital flows to emerging markets resumed a few months ago, but remain at an underwhelming level. After sharp withdrawals in February/March, amounting to USD83bn, capital inflows to emerging markets, both equity and debt, returned to some extent during April-August (USD63bn).

On the equity side, China (USD9.2bn) and India (USD11.7bn) have garnered sizeable inflows, although the prospect of the two economies appear in sharp contrast presently. On the debt side, key recipients of foreign flows have been China, Indonesia, Malaysia, and South Korea.

Debt and equity flows have been largely (and positively) correlated, but lately the correlation has reversed signs (in favour of debt). Over the past four weeks, global investor appetite for EM equities has soured, while enthusiasm for EM debt has remained robust.

Why have certain trades been so correlated so far? In USD asset universe, there are quite a few candidates, the proliferation of index investment, the surge in interest in tech investment precisely at a time when rates are at their floor, and the spike in retail participation in equity markets, have all contributed to the rise in within-and-between asset class correlation, in our view.

Under which scenarios could these correlations break down? Vaccine related developments could sour sentiment on fixed income assets, as markets begin to price in normalisation, in our view. Disappointment in progress against Covid-19, in contrast, could hurt equities. Profit taking from the dizzying returns incurred in recent months could materialise at minor instigations, as already seen last week.

Markets also seem to think that disruptive transfer of power during the November US presidential election is unlikely. We find this complacency remarkable. A Democratic senate, for instance, could lead to sweeping changes in taxation, environmental, and labour regulation, along with oversight of social media companies. A narrow election outcome could cause the defeated not to bow out gracefully. These eventualities could be highly disruptive to the markets’ rosy outlook for 2021.


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Taimur Baig, Ph.D.

Chief Economist - G3 & Asia
taimurbaig@dbs.com


Ma Tieying

Economist - Japan, South Korea, & Taiwan
matieying@dbs.com

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