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The flow of money around the world points at trouble for emerging markets, even if the U.S. and China can break their trade impasse and even as central banks globally seek to cushion any potential economic downturn, investment strategists say.
Nine central banks have cut rates and the Federal Reserve, European Central Bank, Bank of England and People’s Bank of China have all turned dovish. Yi Gang, governor of the People’s Bank said in an interview with Bloomberg that China has “tremendous” room to adjust its monetary policy if the trade war escalates further.
But those watching capital flows see reasons for concern.
There has been a sharp slowdown in the flow of so-called nonportfolio funds—a category that includes foreign direct investment but excludes cash invested directly by individuals, or professional money managers—into emerging markets.
In 2018, foreign direct investments into emerging markets totaled $550 billion, or 1.8% of gross domestic product—the lowest since 1996. Portfolio flows into emerging markets also slowed markedly in April and likely turned negative in May, according to a note from HSBC ’s global emerging markets team.
The team’s models suggest continued weakness in capital flows to emerging markets this year, Murat Ulgen, the bank’s global head of emerging markets, told clients. One reason investors have been drawn to emerging markets is their faster growth versus developed markets. HSBC expects the growth differential to hit 2.7 percentage points in 2019 and 3.2 points in 2020.
That is better than the 2.3 points in 2018, but far from the average 5-point differential emerging markets had over developed markets from 2003 to 2008. The upshot is that the case for emerging market is harder to make than it has been in the past—making investors and companies less likely to put their money there, especially as economic growth slows and trade tensions rise.
For China, foreign investment by U.S. companies and others played a major role in developing its economy. That, too, appears to be headed in an unfavorable direction.
In a note to clients, Bank of America Merrill Lynch’s global emerging- markets fixed-income strategy and economics team say that U.S. companies are likely to shift their investments out of China regardless of which way trade talks go. There is a growing recognition that the U.S.-China conflict isn’t going to be short-lived, creating higher political risk and rising costs for global companies.
And investors have long believed that Beijing wouldn’t allow the yuan to weaken beyond 7 to the dollar, but the PBOC’s Yi also hinted that level isn’t sacrosanct. Allowing the yuan to depreciate would make Chinese exports more competitive, offsetting the damage from rising U.S. tariffs.
“This suggests China is buckling in for the long haul,” wrote Win Thin, global head of currency strategy at Brown Brothers Harriman, in a note to clients on Friday.
As the conflict continues, a recent decline in foreign direct investment in parts of Asia could continue and be “structurally negative for emerging market assets” in the long term, according to the Bank of America team. They noted that U.S. foreign direct investments fell, especially in China, India, Indonesia and Thailand, between 2016 and 2018.
Not all emerging markets are in the same boat. Those in stronger positions offer the potential to become hubs for low-cost production, and are likely to be aligned with the U.S. or European Union if the conflict deepens.
Net foreign direct Investment in China by U.S. firms declined by about $3.1 billion from 2016 to 2018 while it increased in central Eastern Europe by $3.7 billion, and by $7.8 billion in Latin America, according to Merrill Lynch.
Within Asia, Malaysia, South Korea and Taiwan are seeing increased investments from the U.S.
Most strategists expect continued back and forth on trade ahead of the G-20 meeting June 28-29. when President Donald Trump and China’s Xi Jinping are expected to meet. If the two sides don’t make progress, the U.S. could impose tariffs on an additional $300 billion of Chinese exports in July.
That, in turn, would likely prompt China to retaliate, or at least threaten to do so. The weapons in China’s arsenal that are most likely to come into play are cancellations of aircraft orders; an embargo on rare-earth metals, essential for many high-tech products; and currency depreciation, according to Helen Qiao, Asia economist at Bank of America.
Yet if Friday’s weaker-than-expected jobs data leads to a more conciliatory tone from President Donald Trump, it could give emerging- market stocks a lift. The iShares MSCI Emerging Markets index ETF (EEM) was up almost 1% at $41.25 on Friday afternoon, while the S&P 500 and Dow Jones Industrial Average were both up about 1%.
Still, investors may want to keep the longer-term effects of the conflict in mind. They could hold some emerging markets back, even if trade talk turns less hostile.