beyondbrics

The switch in equities from emerging markets to developed goes on apace. In the week to Wednesday, EM equity funds reported net outflows of $2.5bn, up on $1.9bn the previous seven days. This takes total redemptions t0 $23bn since outflows started in late January, according to research company EPFR.

But there is no need to panic. This is not a classic rush for the exit: EM bond funds have actually gained money in the last two weeks. Despite the fears over inflation, oil and the Middle East, investors are keeping their heads.

EM bond funds tracked by EPFR reported an inflow in the week to March 2 of $16m, following an inflow the previous week of $96.9m. These are not huge flows, of course, but they are positive.

In comparison with the $23bn equities outflow since late January, bond funds have lost a mere $1.2bn. Admittedly,  EM bond markets are only around half the size of EM equities in terms of market value.  But the gap is big enough to be significant – showing that bond and equity investors in EMs are behaving quite differently.

EM equities have seen considerable volatility since the start of the year, with a heavy price drop in the weeks to mid-February which saw the MSCI emerging markets equity index fall 5.6 per cent. But since then there has been a 4.7 per cent recovery, leaving the index on 1,138.73 on Friday March 4,  just 1.2 per cent down on its year-end level of 1151.

Of course, the overall figures conceal big variations between national bourses. Russia, the stellar performer, is up a whopping 15 per cent since December. But Indonesia is down  4.5 per cent, Turkey 8 per cent and India 9 per cent – all after rallies since late February. The Shanghai market has recovered the ground lost in January and now stands 4.6 per cent up. Brazil is 1.7 per cent higher.

Chris Weafer of Uralsib, the Russian bank, writes in a note:

The specific concern is that the rising price of oil is putting developing economies under more inflationary pressure than developed economies and may soon lead to growth downgrades in the former.

In contrast to equities, the JP Morgan EMBI+ index of dollar-denominated EM bonds is down just 0.06 per cent on the year. Again there are important variations: investment grade EM bonds are up 1.0 per cent but BB grade instruments (the lowest-rated bonds in the index) are down 2.1 per cent.

Turkey’s bond sub-index is down by 3.6 per cent and Argentina’s by 4.6 per cent. EM local currency bonds are up 1-2 per cent on the year, thanks to modest currency gains.

Three factors are at work. First, bond investors are traditionally less fickle than equity players, with a big buy-and-hold squad, including a growing number local EM pension funds, often bound by regulations to invest heavily in local debt.

Next, while rising interest rates in EMs – including China, India and Brazil – are bad for bonds in general, they are  good for currencies – so increase the attraction of local currency bonds. As one international bond fund manager says: “You get the currency appreciation and you get the carry (interest earnings). So even if the bond price falls the returns are positive.”

Finally – and more fundamentally – the solid performance of EM bonds (and currencies) in the face of volatility in equities and considerable global financial and political turmoil offers more evidence of the growing resilience of EM markets generally. As Alberto Ades, global emerging markets economist at Bank of America Merrill Lynch, told beyondbrics: “Five or 10 years ago, people would pull out all at once from EM equities, bonds and currencies. Now they don’t.”

BofA argues in a report:

Until early last year, investors believed that global emerging markets were all one single risky trade. This paradigm has been changing since May 2010.

One reason is the general positive re-rating of the economic performance of EMs and of their economic policymaking, including monetary policy. Another is the growing depth of local capital markets – with local investors who hold local financial assets cushioning the  impact of volatile international money flows.

But, as Ades says, there “an elephant in the room” in the form of the political risk emanating from the Middle East. So far, this has been largely contained in the region. But the higher oil prices go, the greater the risk of EM-wide contagion. Ades says: “This could still drive investors to leave emerging markets altogether.”

That is true. But political and oil-related contagion on that scale would almost certainly hit developed markets too.

Related reading:
EM currencies: why so stable? beyondbrics
Investors pull $7bn from emerging funds, FT