A rally in emerging market assets last week, which followed moves by leading central banks to reverse flagging sentiment across global markets, is likely to prove short-lived as investors take stock of growing risks to the global outlook, experts have warned.
Both developed and emerging equity markets saw strong gains on the back of coordinated action by central banks in key developed economies to lower the price of dollar liquidity swaps, a move by China to slash the reserve requirement ratio (RRR) for banks by 50 basis-points, and hints from eurozone leaders that closer fiscal union is on the cards.
The MSCI Emerging Markets Index, which tracks emerging market equity performance, rose 9% between November 28 and December 1, while the MSCI World Index, which tracks developed, emerging and frontier equity market performance, jumped 7.75%. Leading emerging and developed market bond yields also fell over the week.
But analysts warned the respite will be brief, especially if eurozone leaders fail at their December 9 summit to agree to decisive measures to put an end to the single currency’s travails, including by granting fresh powers to the European Central Bank.
“Things will go back to risk-off if, as expected, we see that not much progress has been made and we’re still not at the stage where the ECB is getting involved,” said Peter Attard Montalto, emerging markets economist at Nomura.
“In terms of emerging Europe and emerging markets in general, the key concerns are trade linkages with the eurozone, the deleveraging that’s already set in motion and is likely to get worse, and the imminent recession in the eurozone. None of these were altered or resolved by [last week’s central bank action].”
Despite the recent rally, the MSCI Emerging Markets Index remains down 17.18% year-to-date, compared to a 5% ytd fall in the MSCI World Index.
Local money
Recent gains across emerging market assets are more likely a function of local or intra-EM deployments and reallocations, with developed market cross-over investors reluctant to reinvest in emerging assets, analysts said.
“I don’t think we are rallying on the back of actual foreign fund flows. There’s always a lot of domestic liquidity that’s sloshing around and that’s probably what happened,” said Woon Khien Chia, head of Asia local markets strategy at RBS. “It’s really local money that’s driving it, and this is going to be the story for at least the first half of 2012.”
“What we’ve seen recently is a final unwinding of some of the frothy QE2-related flows into emerging markets,” said Montalto. “At the end of September, that was in the form of actual outflows from EM funds into cash, whereas more recently we’re seeing moves within funds, taking profit on Latin American or Asian positions and reallocating them within EM funds, rather than outflows from EM funds.”
Positioning
Despite suggestions that slowing growth and easing inflation concerns elsewhere may trigger monetary easing across emerging markets, significant rate cuts in emerging Asia are unlikely given on-going concerns over structural and commodity price inflation, Chia said. As a result, policy may focus instead on boosting liquidity through open market operations and RRR cuts.
Market rallies are therefore likely to be limited to stock, rather than bond, markets. “If you look at [bond] yields in the region, they’re low and curves are flat. So if things turn rosy or there’s a risk rally, the first place you will go is stocks, not bonds,” she said.
Positioning in currency markets is also likely to prove tricky, given on-going uncertainty over the eurozone, Chia added. “I don’t think you want to run the risk of FX these days with the euro being so uncertain. If you want to hedge, there’s not enough cushion on the rates on the bonds you are holding to pay for the hedges you’re going to put on,” she said.
But emerging currencies have underperformed against their developed market equivalents so far this year, and so could present buying opportunities despite the volatility, according to Nick Chamie, global head of emerging markets research at RBC Capital Markets.
“EM FX has underperformed significantly, to the tune of nearly 4 standard deviations in relation to global markets (S&P500 and EUR/USD are our proxies), suggesting significant asset class outperformance once global market conditions stabilize becoming increasingly attractive,” he wrote in a report published on December 2.
Chamie was also more constructive on EM debt, in particular local currency debt, anticipating rate cuts during the first half of next year, followed by renewed tightening during the second half of 2012.
“This pattern for EM interest rates will see the EM-DM interest rate gap narrow early in 2012 before widening back out in H2, remaining at historically wide levels,” he added. “EM FX and equity look to offer the most value and rates offer the cleanest directional view (lower and steeper) while credit provides the least value, in our opinion, given long-term pressures.”
Short-term underperformance
Nevertheless, EM assets are set to underperform across the board in the near term according to a number of analysts.
“Despite strong fundamentals, emerging assets are likely to remain hostage to the turbulence coming from a very unstable global backdrop,” Pablo Goldberg, head of emerging markets research at HSBC wrote in a recent research report. “Global investors see emerging assets as a risk-on trade. It has been shown many times that emerging assets are highly sensitive to drops in appetite for risk.”
John Higgins, senior markets economist at Capital Economics, expects emerging equity and debt markets to underperform US markets in particular in 2012, even though that picture should reverse in 2013. “We would expect emerging markets to outperform once risk appetite began to pick up given the generally more favourable macroeconomic landscape in the emerging economies compared to developed economies,” he wrote this month.
Strong underlying fundamentals in emerging market economies are likely to be overshadowed by continued short-term investor concerns, Montalto said. “There is still this long-lying structural asset reallocation into EM, but that clearly is overrun by the short-run risk sentiment,” he said. “The volatility of that is clearly much larger and can hide an underlying trend.”
A further round of quantitative easing by the US Federal Reserve would help jumpstart capital inflows to emerging markets from the second quarter of next year, Montalto said.
“We’re looking for QE3 definitely in the first half of 2012, as well as some form of QE from the ECB eventually and we will see a broad repeat of what we saw through the middle and end of last year, namely a lot of long term and hot money short-term flows back into some emerging markets,” he said. “This is probably a theme that will start in Q2 next year and then go through the second half of the year.”
But he warned that while this trend would provide a boost to emerging market asset classes, it would also heighten policy risk.
“Last year when we had QE2, growth in emerging markets was doing pretty well, and therefore the argument of loss of competitiveness through inflows and strong currencies wasn’t really that strong, only in the most extreme cases like Brazil, which saw wild appreciation,” he said.
“But next year you’re in a downward growth trend for these countries. That’s what makes me worry that the currency policy debate may be much more fraught in that environment about loss of competitiveness than it was last year. It’s definitely something to watch out for in the second half of next year as that debate comes back.”