Emerging markets will see less index, more Rolodex

MUMBAI (Reuters Breakingviews) – Investing in poorer countries will require more nuance. Ultra-loose monetary policy from the U.S. Federal Reserve, Bank of Japan and European Central Bank, and unprecedented fiscal stimulus is pushing capital out of mature markets and into developing ones. But ongoing virus concerns will require funds on the hunt for higher returns to be more discerning than they were after the global financial crisis and taper tantrum. Think less index, and more Rolodex.

The recovery in fund flows is already tracking an uneven economic recovery. After a record $83 billion outflow from equity and debt investments in March, there were inflows of an estimated $17 billion in April, according to the Institute of International Finance’s Capital Flows Tracker. Emerging Asia, which includes virus-tackling role models like Taiwan, attracted twice the debt inflows as Latin America. Similarly, President Xi Jinping’s China stood alone in securing net equity inflows, reflecting its head start on getting back to business.

That uneven trend will go beyond the initial virus shock. Countries with similar levels of macroeconomic stability and equal rates of growth may differ wildly on their crisis-management capacity. Some, like Prime Minister Narendra Modi’s India, with limited health resources and struggling to manage the first wave of infections, may be more prone to demand-crushing stop-start relapses until a vaccine is found. These non-financial vulnerabilities can accelerate critical ratings downgrades.

Relapse risk will also make investors more keenly value the financial depth of markets. Take Mexico. Its proximity to the United States, the peso’s status as the world’s most traded emerging market currency by volume, and a responsible central bank may outweigh concerns about its delicate public finances and make the country a sounder investment destination than other Latin American economies with shallower financial markets.

Beyond the destination, there could also be a shift in how capital flows. The higher cost of actively managed funds has in recent years seen business decamp to cheaper passively managed counterparts run by behemoths like Vanguard, but this means more investors automatically must hold certain weights of various emerging markets. Covid-19’s inherent uncertainties may see investors prefer the stewards of their money to have the discretion and local knowledge that comes with a hands-on approach. The wall of capital coming back to developing countries will be built brick by brick.