The flow of hot money into local assets has left emerging markets increasingly vulnerable to a turn in economic and credit conditions, despite improving sovereign credit profiles across the asset class, top analysts have warned.
“Local fixed income markets are liable for volatility, the market is dominated by hot money, the resilience of which has not been tested”, David Riley, managing director of Fitch’s sovereigns group, told Emerging Markets, in comments that echoed key findings of a Fitch report released this week.
Riley pointed out that local-currency sovereign and corporate debt markets are still in their infancy and investors face greater exposure to liquidity risk, local tax changes and, potentially, capital controls.
Paul McNamara, portfolio manager at Augustus Asset Managers argued that yield-hungry investors have become complacent about the risks associated with local markets. “If you indulge in local currency debt you are under their [the sovereign issuer] rules in terms of capital controls and the sudden imposition of taxes,” he told an audience at an Emerging Markets Traders Association (EMTA) meeting last week.
Chrisitan Stracke, senior analyst at CreditSights pointed out that emerging markets remain susceptible to risk aversion. “The downside to the rotation from external to local currency is that if currency risk picks up, investor appetite will drop off,” he told Emerging Markets.
Although Fitch expects improving fundamentals across the emerging markets to act as a buffer against a turn in the global credit cycle, analysts fear the fallout from a US slowdown and housing crisis remains difficult to predict.
Arnab Das, head of emerging markets research at Dresdner Kleinwort argued that emerging markets are unlikely to be the source of a volatility shock. “Whereas in the 90’s financial shocks that hit emerging markets came from within and spread to other emerging markets, the change now is that risks are now external: inflation in the U.S. and the subprime and CDO markets.”
McNamara agreed that the subprime market “is clearly very bad and there are now CDOs people are afraid to mark-to-market, which means there may be more losses to come.” He added that “if you think that US inflation and interest rates are bad, there is scope for the US situation to get significantly nastier.”
Simon Treacher, portfolio manager at Bluebay Asset Management said that, although emerging market investing had become more sophisticated in recent years, the risk remained that a renewed spike in volatility would overturn many investors' differentiation between good and bad credit stories in emerging markets. He pointed out that February’s global sell off, triggered by a drop in Chinese equities market, suggested that emerging markets were still highly correlated.
Riley noted nevertheless that external sovereign debt was more likely than before to weather cyclical changes in investor sentiment: “Investors, more than they were in the past, are thinking increasingly long-term so they will be
pretty sticky even in crises as they want to diversify their portfolios.”
Helene Williamson, EM fixed income fund manager for Foreign and Colonial, agreed with this sentiment. "When you look at the profile of investors today, there are far more real money funds who are prepared to hold assets for the long term and ride out monthly volatility. That has changed even since 2002, when we saw the effect of hedge fund dominance in Brazil markets leading to a big downswing before the election of Lula."
Local debt now accounts for 60% of emerging-market fixed-income transactions, up from 45% in 2004, according to Fitch. Moreover capital flows to emerging markets are increasingly dominated by private sector flows. The agency forecasts total sovereign international issuance will fall to $41 billion this year from $67 billion in 2005. Emerging sovereign bond markets closed June with their worst performance for over a year, losing more than 2% according to the JP Morgan's EMBI+ index.