Investor Sentiment: Emerging Markets Come Into View

This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.

The third quarter brought significant relief for fixed income market returns as economic data softened, inflation faded, and the Federal Reserve (Fed) finally began its easing cycle with a larger-than-expected 50 basis point (bp) rate cut. However, our investor sentiment metrics suggest we should be careful in extrapolating the impact of these moves into Q4.

Long-term investor flows into sovereign fixed income were surprisingly tepid in the quarter, across countries and products (Figure 1). In many cases, quarterly flows were not significantly different from the average, but in the context of such robust market returns they are a cautionary tale. Meanwhile, demand for investment-grade (IG) corporate bonds, gilts and 10-year Treasuries were outright weak. We’ll review what this caution may mean and explore some surprising pockets of strength in emerging markets and Europe.

Bond Holdings Low Given Easing Cycle’s Start

As gloomy as the short-term picture on bond market behaviour looks, taking a broader view across State Street’s measures of long-term investor positioning highlights a more medium-term strategic balance of risks. Our monthly institutional investor indicators show that allocations to equities are still more than 25% of portfolio weight higher than allocations to fixed income assets (Figure 2). This is 5% higher than the 25-year average of 20%. While this allocation gap in favour of equities was higher in the late 1990s and again in the mid-2000s, it’s notable that the gap has shrunk in favour of bonds during each of the three Fed easing cycles in the past quarter of a century.

This insight is reinforced by our work on long-term portfolio construction, which finds that the observed correlation between stocks and bonds since the 1970s is highly regime dependent. Specifically, higher inflation regimes are often associated with positive correlations between stocks and bonds, while low inflation regimes are not. With Fed easing cycles by definition occurring in the latter, we should expect the diversification properties of stocks and bonds to return. In other words, the “everything rally” we have enjoyed at various points this year may not last.

Curve Ball: Positioning Risks for Treasuries Dip

For the first time in 10 quarters, our flow metrics show long-term investor demand for emerging market (EM) sovereign debt was stronger, on a relative basis, than demand for Treasuries. This appears to imply both a stronger, broader risk appetite and a desire to de-risk on US assets ahead of the Presidential election.

The third quarter was good for Treasury returns, but it was somewhat turbulent. At one point, recession concerns were sufficient to prompt market chatter about the possibility of an intermeeting ease. Even after all that, the 50 bps Fed cut, when it came, was still something of a surprise, especially to most economists. On top of that, while inflation data has been well-behaved (see more in PriceStats), labour market data has been both volatile and prone to revision. Against this backdrop — with added election risk through early November — long-term investors have opted to temper their demand for US duration. While flows were weak across the curve over the quarter, they were even weaker in buckets where long-term investor holdings are the highest (Figure 3). It’s likely that this simply reflects a position adjustment in light of the curve steepening that accompanied the beginning of the easing cycle, as well as upcoming event and data risk.

That said, given the relative paucity of potential Treasury demand from other investor types, this will be a key behaviour to watch in 2025, when long-term asset manager demand for Treasuries will be an essential part of the greatly increased funding ask from the Treasury.

Emerging Risk Appetite

For the first time in 10 quarters, our flow metrics show long-term investor demand for EM sovereign debt was stronger on a relative basis than demand for Treasuries (Figure 4). This speaks to more than a reduction in positioning. Investors have been overweight long-dated Treasuries and underweight EM debt for some time. It could hint at a turn in risk appetite in fixed income more broadly.

The beginning of the Fed’s easing cycle could support local currency EM bond markets, especially if it encourages a depreciation of the US dollar, leaving room for further easing from EM central banks. As we discuss in the PriceStats section, encouraging inflation news in emerging markets could boost central bank easing. Also, our metrics of investor behaviour show long-term investors are underweight emerging markets and reassessing that risk in light of potentially improving fundamentals. Third quarter inflows showed a relatively modest recovery, barely above the 50th percentile. But September saw a much stronger swing in sentiment. Inflows rose into the 80th percentile after Fed easing.

Finally, the additional stimulus from the Chinese authorities at the end of September has had an excellent reception in financial markets, which may limit the risk of a sharper downturn in global growth and could further improve the fundamental backdrop for a re-risking in EM bonds.