A major factor underpinning the rally in emerging markets could be coming to an end

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It looks like emerging market (EM) economies are starting to slow down after a strong start to the year, according to new research released Institute of International Finance (IIF).

And that could have ramifications for EM stocks and bonds in the period ahead.

The group’s EM Growth Tracker — a gauge that uses financial, business surveys and hard economic data to determine the outlook for economic activity — fell to an eight-month low of 5.1% in July, driven by weakness in Asia and Latin America.

“The trackers for Asia and Latin America contracted, while the Europe, Middle East and Africa (EMEA) tracker inched higher when compared to last month,” the IIF said.

Source: IIF

The IIF says that while the gauge still points to robust levels of economic growth, activity levels are now decelerating from the levels seen earlier this year.

“All groupings of variables for our tracker performed worse than in June,” the group said.

“The largest decline in contribution to the Growth Tracker came from hard data, followed by business surveys with declines of 0.4 and 0.2 percentage points respectively.

“While the decline in business sentiment is not immediately worrisome, it could be cause for concern if it is followed by further downside among hard data.”

Source: IIF

The moderation in the Growth Tracker also raises the risk that strong inflows into emerging market stocks and bonds earlier this year may also start to reverse.

According to research released by ANZ Bank earlier this month, net inflows into emerging markets in Asia fell to $US3.9 billion in July, the smallest monthly total since December last year.

Bond inflows stood at $US4.7 billion, masking a net outflow from stocks of $US800 million over the same period.

Khoon Goh, head of research at ANZ, put the reversal in stock flows down to a combination of profit-taking, geopolitical concerns an uncertainty over the outlook for monetary policy from several major central banks.

“We noted last month that the conditions for further strong foreign portfolio inflows into Asia were looking less conducive, as the major developed market central banks get closer towards reducing global liquidity,” he said.

Along with US dollar weakness and improved investor risk appetite, strong economic conditions in emerging markets had, up until recently, encouraged strong inflows to the region in the first six months of the year.

With the IIF’s Growth Tracker now pointing to a moderation in activity levels, the tailwinds seen earlier this year may now start to act as headwinds.

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