(Updates throughout, adds background, PMI index, quotes)
By Sujata Rao
LONDON, April 4 Investors are starting to move back in to emerging stocks and bonds after a long hiatus, data from fund tracker EPFR shows, but the economic slowdown gripping the developing world is likely to constrain market rallies.
Emerging stock and bond funds saw their first weekly inflows after more than $50 billion fled in the first three months of 2014, with equities snapping a 22-week losing streak, Boston-based EPFR Global said.
The company, which tracks funds with $23 trillion in assets, released details of first quarter flows late on Thursday, showing that all emerging equity fund categories had shed $41 billion, following $26.7 billion losses in 2013.
But these funds received $2.5 billion in the week to April 2, with 95 percent of this taken in by exchange-traded funds (ETFs), EPFR said, adding that "there were signs of a thaw".
China, India, Russia and Brazil enjoyed the biggest inflows.
Emerging debt funds received just over $1 billion in the past week, EPFR said, noting that the funds had posted outflows in 12 of the 13 weeks in the first quarter, when losses amounted to $17.2 billion.
Banks and investors have started buying back into the emerging market story, noting that sector valuations now are cheap enough to compensate for economic weakness and political risks.
Barclays, Citi, HSBC, Morgan Stanley and Societe Generale are among banks advising clients to buy back in, albeit selectively, with emerging equity valuation discounts having moved to almost record levels versus their developed peers.
"When pessimism about an asset class is this strong, usually that is a compelling opportunity to buy at an attractive price if you have a long-term time horizon," said Austin Forey, investment manager of JP Morgan Emerging Markets Trust.
"There is always the potential for downside but we are in a historically cheap zone."
Emerging equities, at one point down almost 10 percent on the year, are now trading near flat. Year-to-date returns on dollar bonds issued by developing countries, at 3.5 percent, are higher than U.S. Treasuries.
The change in sentiment contrasts with the findings of an HSBC survey that showed business activity in emerging markets fell for the fourth straight month in March, with output contracting in three of the four biggest developing economies .
Based on interviews with 8000 purchasing managers in 17 developing countries, the monthly index, at 50.3 in March, is well below the long-term average of 54.0 and only just holding above the level that would mark economic contraction,
"Emerging markets are going through a rough patch. Lacklustre demand in advanced markets has so far restrained exports. Political uncertainty locally may also be to blame," Frederic Neumann, HSBC co-head of Asian economic research, said.
What's more, HSBC's future output index, which tracks firms' expectations for activity in 12 months' time, also eased as manufacturing expectations weakened.
"The price action and the mood may have turned on EM but given the long period of outflows and EM growth having yet to rebound, we may need a couple more weeks of positive flow numbers to confirm this," Barclays analysts told clients.
Year-to-date, only one emerging markets category tracked by EPFR - frontier equity funds - has finished the quarter with net gains, having taken $815 million, data showed.
"We have turned bullish on emerging fixed income but we are still negative on emerging currencies. The growth picture needs to improve in order for currencies to perform," said Phoenix Kalen, a strategist at Societe Generale.
DEVELOPED STILL IN DRIVING SEAT
Developed equities have outperformed emerging stocks since end-2010. Developed equity funds which got a record $385 billion last year, received $95.6 billion in the first quarter of 2014.
Western Europe outpaced the United States and Japan, taking in $31.5 billion, while European bond funds were also in demand, taking in $15.7 billion in the first quarter.
That's well above last year's record $12 billion inflow. U.S. bond funds received $28.2 billion.
Purchasing managers data this week showed euro zone businesses had their best quarter in three years, with the PMI at 53.1 in March, just off 32-month highs hit in February.
U.S. manufacturing slid slightly but stayed near four-year highs in March and services sector growth accelerated.
Analysts at Deutsche Bank predicted emerging equities would continue to lag despite the recent tentative gains. They predict the main emerging equity index to end the year with 10 percent losses compared to flat returns for U.S. markets. (Reporting by Sujata Rao; Editing by Alison Williams, John Stonestreet)