Emerging markets are going through their roughest patch since the collapse of Lehman Brothers in 2008. Hints by the US Federal Reserve in late May about a possible scaling back or “tapering” of its programme of quantitative easing caused market sentiment towards EMs to quickly turn from moderately bearish to exceedingly glum.
The facts speak for themselves. This week marked the 11th consecutive week of outflows from EM fixed income mutual funds. Returns for the year as a whole are likely to be in negative territory for the first time since 2008. Exposure to EM equities, meanwhile, according to Bank of America Merrill Lynch’s latest Global Fund Manager Survey, is at its lowest level in 12 years.
Caught in something of a pincer movement between the Fed’s planned exit from QE and the China-driven downturn in commodity markets, EMs have fallen out of favour in spectacular fashion.
Yet as is often the case with abrupt shifts in market sentiment, the sell-off is overdone and masks a number of important factors which speak to the resilience of the EM asset class and the need for discerning asset allocation strategies.
Firstly, comparisons with the turmoil in 1994, when the Fed stunned markets by hiking interest rates aggressively, are wide of the mark. Not only has the Fed made it clear that monetary policy will remain accommodative for as long as the US economy remains weak, even the timetable for “tapering” remains in doubt given the patchiness of recent economic data.
The EM asset class, moreover, has evolved tremendously since the early 1990s – both quantitatively and qualitatively. No longer Latin America-centric and composed of non-investment grade sovereigns with poor fundamentals, it now comprises a much more diverse, creditworthy and economically powerful group of countries. While EMs generated less than a fifth of global GDP growth in the early 1990s, they now account for more than two thirds.
Secondly, the current sell-off has been technically, as opposed to fundamentally, driven. A surge in foreign inflows into EM bond funds in the months leading up to the “taper tantrum” made the asset class acutely vulnerable to a sudden deterioration in sentiment. Leveraged positions were quickly unwound in an indiscriminate fashion, throwing the dangers of a “sudden stop” in capital flows into sharp relief.
While sentiment and capital flows have stabilised somewhat over the past month, as the Fed hammers home its message that “tapering is not tightening”, the weak technicals in EMs have shone the spotlight on countries’ fundamentals. EM investors are now forced to do what they should have been doing long before the tapering genie was let out of the bottle: take a hard look at which countries will still have their swimwear on as the tide begins to recede, to paraphrase Warren Buffet.
The pressure points in EMs have become more conspicuous since late May. In a nutshell, they pertain to balance of payments positions, levels of foreign ownership of domestic debt, the “policy space” to react to weaker economic conditions and the outlook for growth. As noted in a new IMF paper on the determinants of sovereign spreads in EMs, these factors affect the sensitivity of countries’ spreads to global risk aversion.
Few countries tick all the right boxes and perceptions of risk differ among investors. Still, the idiosyncrasies of the EM asset class have come into sharper focus since late May, with some countries faring better than others.
One country that has so far proved more resilient than many would have expected is Hungary. Long perceived as one of the riskiest markets in emerging Europe because of its high debt levels and unorthodox policies, Hungary was the only country in the region not to suffer foreign outflows from its local bond market at the height of the financial turmoil in May and June.
The forint has remained fairly stable, losing only 1.7 per cent against the euro in June, compared with a 3.6 per cent slide in the Polish zloty. While the currency has weakened a tad of late, an uninterrupted monetary policy easing cycle, a current account surplus and signs of stronger pre-election fiscal discipline are underpinning favourable sentiment towards Hungarian assets.
Increasing evidence of an economic upturn in Germany, Hungary’s main trading partner, bodes well for an export-led recovery. The big risk, however, is the 40 per cent non-resident share of Hungary’s domestic debt market, one of the highest in the EM space.
Indonesia, on the other hand, has fallen from grace in the realm of risk perceptions. Having until very recently been seen as one of the most resilient EMs – both regionally and globally – because of its large domestically driven economy, it is now one of the most unloved markets, laid low by a collapse in commodity export prices and poor macroeconomic management.
The rupiah has shed 5.3 per cent against the US dollar since late May, while the yield on Indonesian 10-year debt has shot up nearly 200 basis points. Among the local currency bond markets in emerging Asia, the 32 per cent foreign share in Indonesia is the highest in the region and now on a par with Malaysia’s. Although debt levels remain relatively low, Indonesia’s balance of payments position has deteriorated significantly, while inflationary pressures have triggered hikes in interest rates. Indonesia’s growth story now looks much less compelling.
All this speaks to the importance of distinguishing clearly between EMs and paying more attention to country-specific conditions. For investors who do their homework, there are still plenty of opportunities in the EM space.
Nicholas Spiro is managing director of Spiro Sovereign Strategy
Guest post: as China slows, Europeans rethink their strategies, beyondbrics
Guest post: what explains the Chinese and Russian stock discount? beyondbrics