The reflation trade rally

Emerging markets, except China and Russia, have done better than the US in 2017; French elections and Trump administration’s policies could be key tailwinds

The revival in risk appetite of foreign portfolio investors (FPIs) seems to have given emerging markets (EM) a much-needed impetus in 2017. During the calendar year so far, EMs have registered decent gains, tracking the rally in US markets. While Indian markets, with 20 per cent gains in dollar terms, have emerged as the best performing market in 2017, all the others, except China and Russia, have yielded better returns than the S&P 500 in dollar terms. Return of foreign flows and strengthening of local currencies have been the key factors behind this superior performance of EMs.

Market participants say this buoyancy in the EMs is on account of the so-called “reflation trade”. Reflation is stimulation of an economy by increasing money supply or by reducing taxes to bring back growth. After Donald Trump’s victory last November, big-ticket global funds took bets on equities, in anticipation of tax cuts, revival in growth and pro-market measures.

Until November, the prospects of growth had looked dim amid concerns about China and political developments like Britain’s exit from the European Union (Brexit). Reflation trade is a phenomenon where investors switch to high risk products like equities from safer products like bonds, in anticipation of better growth and returns. FPIs have pumped $18 billion into EM equities, excluding China, in 2017 so far, and have remained net buyers in all markets except South Africa. While Mexico saw flows to the tune of $9.5 billion, India attracted investments of $6.5 billion. FPIs bought equities worth $2 billion and $0.9 billion in Russia and Brazil, respectively.

“Many EMs enjoyed favorable conditions, helped by the softer dollar, solid demand from China and an absence of protectionist trade measures from the Trump administration so far,” said Christopher Molumphy, chief investment officer, Franklin Templeton Fixed Income Group, and his team in a report.

Molumphy, however, has warned that the rally in EMs might not be sustainable, as the underlying global economic growth remains sluggish. “Sentiment indicators may have picked up across much of the world but large parts of the global economy continue to rely on substantial monetary stimulus, and political risk remains a significant concern for investors, in both Europe and the US.”

Market participants say going forward investors will be more bothered about political outcome in major economies than the monetary policy of key central banks. One of the key triggers could be the second round of French elections slated on May 7. Investors fear a victory of farright candidate Marine Le Pen could trigger a Brexit-like scenario in France, which could pull curtains over the EU and free trade on the continent.

“The results of the first round of French elections have provided some relief to investors about a Brexit-like fallout. Going forward, the markets would be closely watching the policy measures adopted by the Trump administration. Performance of the Chinese economy and geopolitical tensions in Syria could also be major tailwinds,” said Andrew Holland, chief executive officer, Avendus Capital Alternate Strategies.