Emerging markets have always enjoyed a reputation for being risky places for investors and in the past few months the dangers they represent have shown their ugly face in a big way.
Uncertainty about US monetary policy allied to poor economic data from China has fuelled a flight from the asset class. Yields on government bonds, that not long ago sold like hot buns, have widened sharply.
Equity markets have fallen dramatically, especially compared with the good performance of stocks in the US. The gloomy mood has been compounded by scenes of social and political unrest, peppered by violent reactions from the security forces in countries like Turkey, Brazil and, more tragically, in Egypt.
With such images in mind, it is probably not surprising that many investors have decided to cut their losses and run, leaving behind what appears to be an increasingly desolate political and economic scenario.
The fall of emerging markets has been brutal. In the year to early June, the MSCI Emerging Market index, made up of stocks from the group of countries lumped under the EM umbrella, had left more than 14 per cent of its value on the table. Investors in Brazilian stocks were over 24 per cent to the worse and those who had in their portfolio Peruvian equities were almost 34 per cent down from the levels of 1 January.
Talk about the extent to which the main axis of the global economy was shifting from the developed world to the likes of the Bric countries was quickly replaced by the acknowledgement of structural deficiencies in the Chinese credit sector and the frailty of emerging currencies.
The IMF joined the Cassandras by reducing its global economic outlook in July mostly owing to weaknesses in emerging markets, which the IMF now expects to grow, as a group, by 5 per cent in 2013, which is 0.3 points lower than its previous forecast, released in April. In 2014, it estimates growth should reach 5.4 per cent, which is also 0.3 points below the previous estimates, which, as GDP growth numbers go, is not bad at all.
On the contrary, a 5 per cent GDP growth rate remains a far-flung proposition to places like the US, Japan and Germany, which have replaced emerging markets as the darlings of global investors since mid-May. In fact, a close analysis of the statistics from both groups of countries could very well make one wonder what the change of mood is all about.
“The underperformance of emerging markets so far this year compared with developed markets is quite surprising,” says Allan Conway, the head of emerging markets equities at Schroders. “The reality is that, if you look at the absolute numbers of economic growth, fiscal position or current account, they look much better than developed markets.”
”Analysis begins here on trying to guess what is going on in the mind of Bernanke”
For a long time, emerging markets have been grouped together in the minds of many investors as a single asset class offering a kind of risk/return relationship that most investments in more mature economies were unable to deliver. One of the characteristics of emerging markets was a tendency to be the target of uncontrollable bursts of panic as soon as risk aversion set in the market.
Since the start of the current crisis, however, much ink has been devoted to the fact that perceptions about the risks involved in investing in emerging markets have become much less acute. This was especially true if compared with the fear injected into people’s minds by pearls of the developed world like the US and UK banking systems and the single European currency.
Increasing interest in emerging markets has also made many people realise how heterogeneous the group is. The EM umbrella encompasses over 60 countries with a wide range of economic structures and growth potential. In recent months, however, a whole bunch of investors have shown little inclination to giving emerging markets their due recognition.
“We have seen this story a million times already,” says Jan Dehn, the head of research at Ashmore Investment Management. “A panic grips markets when a big piece of uncertainty emerges. People get scared and then they start selling out their exposure to emerging markets.”
The panic this time can be traced back not to a dramatic event like the bankruptcy of Lehman Brothers or the revelation of accounting gimmicks by the Greek government but to a speech given by the chairman of the US Federal Reserve Ben Bernanke in May. Talking to Congress, Bernanke hinted at the possibility the Fed could gradually close down its quantitative easing policies as the recovery of the US economy gains pace.
He did not announce any dates for the process to begin, nor indicated which set of economic statistics would trigger it. But what has become known as the threat of “tapering” by the Fed has taken the form of a giant sign to sell risky assets, a qualification that still applies to most emerging market securities in the minds of investors. Tapering speculation has generated a massive outflow of money from developing economies, reverting a trend observed in the first quarter of 2013.
“Inflows to emerging markets were very strong in the first quarter of the year and that is because in the previous 16 months they had delivered spectacular returns,” Dehn says. “A lot of people came into the market at the very tail-end of the rally.”
In Dehn’s view, the reaction of late arrivals to the Fed’s tapering risk constituted one of the factors that ended up creating the emerging market downfall observed since May. But other problems unrelated to the actual state of the affected economies have also played a part.
According to Dehn, in around April, investment banks began to speculate there was going to be a huge outflow of money out of Japanese government bond markets and into emerging markets. “One particular group of investors, formed unsurprisingly by hedge funds, bought into the idea,” he says. “They helped fuel a very strong rally in local currency bonds in April.”
However, in the end, most of the money that went out of Japanese government bonds headed to the Japanese Stock Exchange, Dehn notes, hitting the strategies of many a speculative investor.
In this scenario, still following Dehn’s analysis, the tapering talk by the Fed had two important implications. First, it triggered a sell-off in the Japanese stockmarket. Investors went back to government sovereign bonds and as a result the inflow of Japanese money into emerging markets expected by hedge funds did not materialise.
Second, as a result of ongoing efforts to adapt their balance sheets to meet new capital rules, banks reduced the money available for emerging market trades, which consequently drained liquidity out of the market. When the hedge funds that had bet in the spike of emerging market assets as a result of feeling Japanese investors, there were few takers for their holdings. As a result, many had to settle for lower prices in order to cut their losses.
In this analysis, the actual evaluation of the current state of emerging market economies in investment strategies is conspicuous by its absence. “The sell-off has not been driven by material change in fundamentals,” Dehn points out. “Yields on emerging market bonds have widened, currencies have weakened and equities have come down but fundamentals have not really changed.”
There is little doubt that, in the recently ended rally of emerging markets bonds, the most important factor was the prompt availability of cheap money made possible by the lax monetary policies of the US, European, UK and, more recently, Japanese central banks.
Quantitative easing has in fact been a driver of rallies in other markets too, including equities and corporate bonds in the developed world. But, differently from the latter, there is not a central bank to absorb unwanted emerging market bonds, says Chris Palmer, manager of the Henderson Emerging Markets Opportunities fund. Therefore, bond holders have to find other buyers if they want to get rid of them, which allows for large ups and downs in prices.
“Markets are not that liquid for emerging markets debt, with the exception of a few like Brazilian and Mexican government bonds,” he says.
But it is also true that a number of the biggest emerging market economies face challenges to their growth perspectives that have become more evident in recent months. China, the world’s second-largest economy, has seen a significant economic slowdown and worries have been voiced by many economists about the state of its credit sector. The new Chinese government has also indicated that it will adopt a less active part in boosting the economy than its predecessor.
“There is a realisation that policy in China will be less accommodating than before,” says Brian Coulton, an emerging markets strategist at Legal & General Investment Management.
For its part, Brazil needs to deal with the double whammy of slower-than-expected economic growth with upward inflationary pressures, a dreadful combination that could give rise to the stagflation scenario that economists fear so much. Coulton notes the Brazilian economy has also been hampered by a bad mix of policy moves by the government, including a number of protectionist measures that have brought about little results but have affected investors’ confidence.
“Growth has been coming through more slowly than many people expected and at the same time inflationary pressures have been worse than expected,” he says.
China and Brazil are key emerging markets, the former because of its sheer size and ability to move the global economy one way or another, the latter owing to the high liquidity provided by its securities. Their performance is therefore an importanfactor behind any bullish or bearish appreciation of emerging economies. For many, in fact, China has become a more important driver of the asset class than even the Fed’s QE policies.
“What appears to be holding emerging markets back right now is China, which seems to be slowing down quite dramatically,” says Jason Pidcock, manager of Newton’s Emerging Income fund. “In the very short term, more negative economic news coming out of China will put pressure on share prices in emerging markets.”
But problems can be found elsewhere too. The deficits of Turkey and South Africa are a concern and Russia remains too reliant on unreliable energy prices, according to analysts. Perceptions are important and the view of the market was aggravated by the images, in the past year or so, of furious hordes protesting about all kinds of things on the streets in South Africa, Turkey, Brazil, Egypt, Russia and other countries.
Furthermore, the looming end of QE has fuelled a drop of emerging market currencies against the dollar which has hit investors who held stocks which were quickly losing value at the same time. It also means that emerging market governments will find it more difficult to raise money abroad in order to boost economic growth and they have been understandably cautious when it comes to tapping hard-earned foreign reserves.
Many of the governments in Latin America, Asia and Africa have been using a combination of low interest rates and some kind of stimulus programmes to boost domestic consumption and the retail activity,” Henderson’s Palmer says. “But there are limits to how much this can be done, either because of fiscal constraints, constitutional limitations to debt issuance and also the public’s capacity to add any more debt at the household level.”
Consequently, this process is beginning to lose steam, with retail sales growth going down a gear or two about everywhere in the emerging world.
“Consumer activity has been one of the key drivers of economic growth in emerging markets and it is starting to slow down,” says Palmer.
Less positive perspectives across the board were made official by the latest update to the IMF’s World Economic Outlook, released in early July. The IMF slashed its previous forecast of economic growth this year by 0.9 points for Russia, 0.8 points for South Africa, 0.5 points for Brazil and Mexico, 0.3 points for China and 0.2 points for India.
Overall, the numbers are still quite good – China’s performance this year should amount to a 7.8 per cent expansion, according to the Fund’s forecast. But they look disappointing compared with previous performances, like China’s 9.3 per cent GDP growth in 2011, and the improvements recorded in other parts of the market, especially with the less risky US and Japanese economies looking set for some degree of rebounding, modest as it is likely to be.
Looking to the future, the developments of recent months raise an important question for the clever investor – is it time to take advantage of lower prices and get into emerging markets again? In this respect, most fund managers show a preference for a prudent approach. They note that the global economy appears set for a recovery more worthy of the name than the modest improvements seen in recent years and that should bring benefits to emerging markets which have strong fundamentals in place. The several million dollar question is, of course, whether the decline of asset prices has reached bottom or still have some way to go?
Again, analysis here begins on trying to guess what is going on in the mind of that man Bernanke.
“Depending on how steep the US yield curve becomes, there is potential for further outflows in emerging markets,” says Sandra Crawl, a member of the investment committee at Carmignac Gestion. But she also notes it is worth starting to take a look at this option right away. “The time has come to once again buy into emerging markets but with focus on countries with good fundamentals. Brazil and China are not among them,” she says.
Schroders’ Conway, for his part, says that opportunities can already be found in the market, even though it is not possible to tell whether they will not look even better in a few months’ time. “Because of the underperformance of emerging markets so far this year, they are very attractively priced right now,” he says. “Valuations are very supportive and the economic fundamentals, even if we are downgrading some of them, remain very positive.”
In Conway’s view, the decision of diving into the market should really be linked to the time horizon that each investor has in their investment strategy. “Money invested today will show a very good return in a three-year horizon,” he says. “The problem is between now and the end of the year, when you could still see some underperformance of emerging markets. There could be in the very near term a better buying opportunity.”
“At the moment, emerging markets do not have a lot of upside,” Pidcock says. “But once we leave the current phase, they will have good upside again.”
When investors feel confident the tide has tuned again, the question is where they can find the best opportunities. Pidcock, for example, says the less impressive performance of China will have a strong say on who will be the winners and losers in the emerging world. “South Africa, Brazil and possibly Indonesia, who rely on commodities, should struggle,” he says. “But countries that benefit from low commodity prices, like Thailand, Philippines, India and Mexico, will probably do better.”
LGIM’s Coulton, for his part, likes the perspectives for India. It is true, he says, that India has a large deficit and has faced a lot of pressure on its currency but it has also done things correctly in terms of policy. “The government has started to get its act together on the reform and fiscal side. For example, it has recently passed a reform of gas prices, which is a huge deal in a country like India,” he says.
India has also recently improved the way it approves investment projects and has allowed foreign direct investment to be made in the vital retail sector. Coulton also points out that India’s trade deficit looks close to peaking and growth, at less than 5 per cent a year, is probably as low as it is likely to get. He expects therefore some rebounding of the Indian economy.
A worry for investors in India is the weakness of the rupee but that is hardly a peculiarity of the South Asian country. “If you want to invest in India, and probably most other emerging markets for that matter, you should hedge the currency,” Crawl says. “Emerging market currencies could continue to devalue against the dollar, given we anticipate a strong US dollar.”
In any case, it is necessary to look around and pick and chose the right opportunities in the emerging world, she points out. “Mexico has gone through some structural reforms.
It has proximity with the US and offers a cheap labour force, so it is a good area to invest in,” she says.
She adds: “Saudi Arabia and the United Arab Emirates have strong reserves and currencies practically pegged to the dollar. They are stable and appear as good places to invest too.”
Before jumping in, however, investors should drop some long held and often outdated assumptions about emerging markets, the experts say.
One of these assumptions is that the woes of one emerging market in particular is likely to spread around the group like wildfire. “Internal political problems in Brazil do not change the investment outlook in Mexico or the Philippines,” Ashmore’s Dehn says. “The age of contagion in emerging markets is many years behind us.”
Another perception Dehn has no time for is the one that purports that political agitation in a developing country will necessarily mean future headaches for holders of bonds issued by its government. “Just because countries have political problems, it does not mean that their willingness to pay their debts is going to change,” he says.
Another still prevalent view is that the future of emerging economies is inextricably linked to the performance of commodity markets. “This is not true anywhere,” Conway says. “The importance of energy and raw materials in emerging markets has declined significantly.”
And a further misplaced myth is the one that establishes that the fate of emerging markets rely upon their exports to the developed world. Conway says trade between emerging markets is a major trend today while domestic demand is fuelling economic growth too.
“Today, the emerging economies export far more to China than to the US,” he said.”Fifteen years ago, it was about emerging markets doing business with developed economies, selling them commodities. Now it is more about them doing business with other emerging markets.”
The influence of the developed world is much likely to be felt today via the financial markets and their reactions to any word that comes out of Bernanke’s mouth.