Emerging markets have been an exciting place to invest in. High rates of growth and large current account surpluses have made many of these markets highly desirable. Particularly welcome has been their apparent ability to carry on their success stories despite the credit crunch, which is crippling developed markets.
But all this has changed. In recent months investors have started pulling out of emerging markets just as they have elsewhere in the world with the pace of outflows picking up sharply in recent weeks.
In the last week of September, outflows from emerging markets equity funds were $1.6 billion (£900m) bringing outflows the year to date to $33 billion says EPFR Global, a Boston-based data provider. These outflows represent 5.9% of total assets and the last time outflows exceeded this was in 2001 when full-year outflows were 6.4% of total assets.
In a note EPFR says: “The third quarter was not kind to EPFR Global-tracked emerging markets funds, as investors abandoned all faith in the so-called “decoupling” of the US and emerging economies during the current business cycle. Emerging markets equity funds, which accounted for 10% of the $113 billion investors had pulled out of all equity funds year-to-date in late June, ended September accounting for over 25% of year-to-date outflows”.
This exodus from emerging markets equities is backed up by research from Merrill Lynch. In its September fund manager survey, it discovered investors had moved to their most risk-averse mindset yet recorded and this had resulted in fund managers being their most underweight in emerging markets equities since 2001. The survey of 186 fund managers who control $641 billion of assets, was carried out before the failure of Lehman Brothers and the bail-out of AIG, which prompted one of the biggest sell-offs in years.
Further bad news came from Morgan Stanley, which warned that the banking sector crisis could cause inflows into emerging markets to fall by a quarter, increasing the risk of a global recession, and even a currency crisis. It warned capital flows to emerging economies could drop to about $550 billion in 2009 from an estimated $730 billion this year.
While the rate of outflows from emerging markets is eye-watering, it is worth noting that such was the high level of investment into these markets recently, that so far it is only recent inflows that have been wiped out, says Oussama Himani, a global emerging markets strategist at UBS.
“Over the past two to three years we have still seen positive cumulative inflows into emerging market funds. It is only the inflows from last July to the present that have so far been wiped out,” he says.
But as investors withdraw from these markets so it becomes more difficult for them to perform well, says Alex Ingham, an emerging markets fund manager at Aviva Investors.
“US investors in particular have been taking money back and are likely to continue. Outflows have picked up and emerging markets have started to perform poorly due to a lack of liquidity,” he says.
In the three months to October 1, the MSCI World index fell 7% but the MSCI Emerging Markets index was down 16.8% and the FTSE All World Emerging Europe index was down 27.8%. Fortunes have varied among the Bric (Brazil, Russia, India and China) markets but in the past month they have all suffered double digit falls of between 16% and 22%.
So what has caused investors in emerging markets to take flight?Initially it was concern about how emerging markets would be affected by the slowdown in world growth. Inflation worries and falling commodity prices coupled with the strength of the dollar dampened enthusiasm for many of these markets as did geo-political concerns.
Investors started to lose confidence that the underlying growth story and momentum in these markets could survive intact through a much broader global downturn, says David Riley, the head of sovereign ratings at Fitch Ratings.
“The idea that emerging markets would be largely immune from the downturn in the US no longer holds up. Evidence shows a slowdown in growth in emerging markets and the downturn led by the US is becoming more broad-based. So there’s been a reassessment for the outlook of emerging markets. Traditionally, emerging markets have been seen as a leveraged play on global growth so if you become more negative on global growth clearly that’s going to hurt emerging markets,” he says.
But despite this, emerging markets appeared to be insulated against the worst effects of the credit crunch. However, the deepening crisis in the global financial system has resulted in a sharp rise in risk aversion, which has been bad news for emerging markets. The collapse of Lehman Brothers in mid-September saw a surge in the sale of emerging markets assets, which left these markets reeling.
Withdrawals from emerging markets equity funds have been across the board, with both retail and institutional investors reducing their holdings. Fund managers and global asset allocators looking to reduce risk in their portfolios see reducing their exposure to emerging markets as an obvious choice. A lot of non-dedicated money, such as investment by those who do not have a mandate to invest in these markets, has also probably left, says James Syme, head of emerging market equities at Baring Asset Management.
But long-term investors in emerging markets such as pension funds where consultants are involved, are unlikely to have made strategic switches into and out of assets this fast, says Alan Tarver, a global emerging markets product specialist at HSBC Global Asset Management.
“A lot of the movement occurring in and around emerging markets has been in institutional-style. Large investment funds, such as pension funds, which do not use advisers, institutional own-house money or own portfolio money – these are the faster moving investors. If there are advisers in the background, such as IFAs, consultants or bank advisers, and they are comfortable with the fundamentals for emerging markets, they will be telling their clients not to switch out of emerging markets,” he says.
HSBC, Fidelity and Barings all say they have not yet experienced significant outflows from their emerging markets funds.
Much of the money flowing into emerging markets over the past three to four years has been foreign but in the background have been domestic investors and we have also seen the creation of domestic mutual fund industries, says Tarver. What will be interesting is to see how domestic investors react to the situation he says.
“When I was in India there was a huge sense of national pride in investing in your own market. But some emerging market domestic investors are fairly new to equity investment and haven’t seen a disappointing cycle so it is hard to tell which way they will jump,” he says.
Himani also says domestic investors are becoming increasingly important.
“Local investors in emerging markets have become quite important and in a lot of countries more important than foreign investors. For example, in Poland we saw the market rally dramatically and correct shortly because of the behaviour of local investors. There are also countries that have significant local fund management industries such as South Africa, Brazil and Korea,” he says.
A clue to how domestic investors may react can be found in a survey carried out by the Economist Intelligence Unit on behalf of Barclays Wealth. The survey of 2,300 high net-worth investors discovered that investors based in emerging markets are more likely to increase their risk appetite during volatile times, says Greg Davies of Barclays Wealth.
“During volatile conditions, survey respondents from emerging markets, including China (41%) and India (40%), say they are more likely to increase the level of risk in their portfolios – indicating that they regard the current environment as one of opportunity, rather than a hindrance,” he says.
There is a universal home bias towards domestic markets that is generally stronger in emerging markets, says Davies with investors typically seeing investments in their home markets as lower-risk and more desirable than investments abroad.
“Emerging market investors are also much less likely to diversify globally than developed market investors,” he says.
So will outflows from emerging market equities continue? Brad Durham, managing director of EPFR Global, says so.
“In previous global sell-offs of such severity – and you can argue that this one is the most severe this decade – it has taken a number of months for investor confidence to return. But if a major financial rescue plan is adopted in the US, and works to bring confidence back into credit markets and among equity investors, then I could see a sharp rebound in emerging markets and inflows into funds investing in these markets in the short term. Valuations are at severely beaten down levels through most of the emerging markets universe. Over the longer term I think flows will be dependent on the extent to which global growth slows and the impact this will have on emerging markets,” he says.
Ingham also expects outflows to continue until risk appetite comes back.
“Until we have clarity on the US problems and the eurozone getting through the recession I expect this to continue. While emerging market fundamentals may be okay, if you’re an investor sitting in the US or UK and your own economy is sufferingyou are less likely to push the boat out on risk,” he says.
In recent weeks we have seen some wild swings in the fortunes of emerging market stockmarkets. Neil Shearing, an emerging Europe economist at Capital Economics, expects more of this.
“We could be entering a period where emerging markets bounce for a while. We are not out of the woods for the credit crunch yet so it would be wrong to think we’ll see an unbridled rally over the next 12 to 18 months. The sell-off went beyond what you would expect from the economic fundamentals. Once normal economic conditions resume you would expect markets to rally but we’re not there yet,” he says.
Of course, some emerging markets have suffered more than others. The markets most affected are those that received the largest amount of new money the previous year such as China, Russia, India, South Korea and Taiwan, says Peter Hicks, executive director, UK retail, at Fidelity. He points out that countries such as South Africa where there was not anything like as much new money over the past 12 months, have held up relatively well over the period. This is a correlation between the amount of new money that has gone into the markets in the last 12 months and the withdrawals from people chasing returns. This is what you would expect,” he says.
Commodity producing countries, such as Brazil were hit by falling commodity prices while Asian equity markets look “frothy” since last year with valuations stretched, says Shearing.
Emerging markets with particular issues have been hard hit by the more recent outflows of the past three months. For example, geopolitical worries have savaged the Ukraine stockmarket, Hungary has seen a sharp sell-off on growth worries, while political turmoil in Pakistan has seen the market plummet. And of course Russian stocks are still reeling from a combination of falling oil prices, the war with Georgia and worries over government interference in investments.
The other Bric countries have also seen their stockmarkets fall sharply, although in the past month the rate of falls has slowed considerably in India, according to the MSCI indices.
Asia excluding Japan has been particularly hard hit, says Durham.
“China equity funds have held up pretty well, but the Greater China funds, or those investing in mainland China, Hong Kong and Taiwan, have had about $4.5 billion of outflows while Korea funds with $1.6 billion of outflows have been hit the hardest, since those outflows amount to about 20% of their total assets,” he says.
So what is the outlook for emerging markets? “It depends on the current financial crisis and its impact on investor risk aversion,” says Durham.
“If confidence returns fairly quickly, then the outlook is good since growth and fiscal balances are still relatively strong in the EM [emerging market] universe, and inflation concerns are abating with commodity prices dropping. But if investor confidence doesn’t return quickly, then I think it’s going to be rough sledding into 2009,” he says.
Many feel that things are going to get worse before they get better.
“The long-term outlook is still positive, but it will be tough for another nine to 12 months,” says Ingham.
“We’ve had four good years of emerging markets so it is not surprising we are seeing some profit taking. But I think there will be a slower world economy for a little while as banks and the whole financial system deleverages in the US and across Europe and the developed world. In that environment growth will be slower and that is slightly more negative for emerging markets.
“But emerging markets look relatively cheap now and over the long term I think you will still make more money in emerging markets than in developed markets,” he says.
Syme agrees. “In the near-term something needs to change to get investors to increase their risk allocation and I can’t immediately see what will do this. But the long-term story is still good for emerging markets. If you look at where the subprime and mortgage-backed problems have emerged it has been exclusively an OECD [Organisation for Economic Cooperation and Development] phenomenon. The credit crisis is not an emerging market problem. The basic story for emerging economies remains very strong. They are cheap and this will drag investors back in,” he says.
This faith in the emerging market story is echoed by Tarver. He points out that even if growth rates fall, they will still be greater in emerging markets compared with developed markets.
“Following the recent sell-off, both earnings and asset valuations for the asset class are extremely attractive and at a sharp discount to the developed market equities despite a much more favourable growth outlook. While liquidity issues are affecting GEM [global emerging market] equities in the near term, the asset class does not suffer from the grave solvency issues the developed world is grappling with. We believe the asset class is due for a rebound from the current oversold levels,” he says.
Recent outflows from emerging markets do not appear to be as a result of a fundamental loss of confidence in emerging markets but rather a move away from higher-risk investments.
So with prices sharply lower but the basic belief in emerging markets offering better growth potential than developed markets, is now a good time to invest? It all depends on how much further you think these markets will fall, says Himani.
“It’s hard to say if we’re near the bottom. But we are at valuations we haven’t seen since the depths of the Asian crisis and Russian defaults in the 1990s. So the market from a valuation point is cheap,” he says.
Tarver is also unsure if we have reached the bottom. But even if we haven’t it cannot be far off he says.
“A lot of strategists are saying if we haven’t got to that floor yet then we’re close to it. Now would be a good entry point if you’re prepared to accept that there may be more pain in the future but that really we’re close to the floor. If you waited for the floor you might be waiting for ever and then might miss it,” he says.
All interviews were carried out just before the $700 billion financial rescue plan was agreed. lWhat the fund managers sayStockmarkets in emerging markets have been highly volatile. We asked three fund managers what opportunities this has created for them.
Alex Ingham of Aviva Investors
“We have made some changes but not a huge amount because firstly, the market has become highly rotational and volatile, which means you have to be careful which day you trade on.
Secondly, the current newsflow affecting the market is changing rapidly, and with big consequences. Thirdly, volumes have dried up in emerging markets, which means trading is more expensive than normal.
“We are selling stocks we don’t like when the market has a good rebound after a bad day.
“We’ve sold a couple of banks that we thought might be vulnerable in Asia, but have replaced them with lower-risk banks in Latin America. We’ve reduced some of the cyclical exposure we had in Taiwan.
“However, it does not look like we are at the bottom yet, so we are still cautious. We continue to avoid some of the eastern European countries with more precarious current account balances, and are biased towards Latin America and Asia. Within Asia we are cautious on Korea and Taiwan, but are warming to them.
“In Latin America our bias is towards Mexico. Russia has become very cheap, but we think it is too early to go overweight. We continue to be underweight in energy and have less materials, but have added to banks, utilities and telcos.”
Alex Tarver of HSBC
“We have been slowly increasing weightings in selected stocks. However, we have not altered our core strategy. We maintain our mild portfolio bias to growth cyclicals in the oil, coal and materials sectors on account of their extremely attractive asset valuations and the belief that the consensus view of demand destruction that stock prices are reflecting is too negative.
“At the country level, the biggest addition has been to Russian equities. We have added to Brazilian resource stocks and Asian financials. The purchases have been financed largely from a reduction of our holdings in the GCC [Gulf Cooperation Council] markets.
“We see a lot of value in oversold growth cyclicals in the Bric markets [Brazil, Russia, India and China] as well as selective financials. Select Asian banks have sold off in sympathy with global peers and concerns about falling liquidity but themselves exhibit strong, underleveraged balance sheets. They are attractively priced on book multiples – in some cases at a small discount to book. We have reduced the fund’s exposure to the Middle East, which had not fallen as far until August, to fund other purchases”.
Nick Price of Fidelity’s Emerging Europe, Middle East and Africa fund.
“The market has been very volatile and driven by sentiment, which tends to divorce the true value of companies from their stock prices in the short term – this opens up opportunities for investors with a longer time-horizon.
“I had started spotting an imbalance in the supply/demand picture for soft commodities such as potash early on and bought fertiliser companies benefiting from a subsequent rise of the potash price. Towards the summer the valuations were getting expensive and so I started to reposition the portfolio in anticipation of a fall in materials stocks.
The fund has been underweight in materials stocks since, which has been beneficial as the materials sector underperformed.
“I am finding good value in consumer stocks in South Africa: As interest rates have increased over the last three years and inflationary pressures from high energy and food prices have come off slightly, we are likely approaching the peak of the interest rate cycle.
“The expectation of lower inflation and the subsequent potential for interest rate easing will be able to lift pressure from the consumer and free up disposable income. This will benefit consumer stocks such as retailers.” Developed versus emerging markets