Emerging market equity fund managers are fully invested and shrugging off fears over US-related credit risk, the latest Merrill Lynch survey of 186 global equity asset managers has shown. Indeed, Michael Hartnett, emerging market equity strategist for Merrill Lynch, noted that the asset rotation out of US and Western European financial institutions, due to fears over rising interest rates and subprime mortgage losses, appeared to be directly benefiting emerging market equities.
“Cash balances are at 3.4%, which is the lowest since our survey began in 1998. Our composite risk appetite index has now reached 42. If it crosses 45, then we will start to watch very closely, as this is a level which normally coincides with a large EM sell-off,” said Hartnett.
The survey, which covers managers responsible for assets totalling almost $620 billion, included for the first time questions on what investors saw as major threats to global financial stability. This highlighted expectations of a fundamental disconnect between the growing credit storm in the US and the strength of emerging markets. A net 72% of respondents saw the risk from credit quality as above normal levels, whereas a net 18% saw the risk from within emerging markets as below normal.
“In a way, equity investors are playing the subprime story by shorting the dollar. At a time of deteriorating credit quality, you sell debtors and buy creditors – today, that means buying emerging markets such as Russia. We are seeing almost panic buying, as paranoid bulls start to shed their paranoia and believe that the positive story can be maintained,” said Hartnett.
However, he told Emerging Markets that interest rate cycles in individual countries were starting to become a more important factor. Already, investors are underweight Poland, South Africa and Chile, which have embarked on monetary tightening – even though the latter two are commodity producers likely to benefit from dollar weakness.
“Corporate leveraging in emerging markets is less than in developed countries, but it is catching up fast at this stage of the cycle. That means you will soon reach a point when investors focus more on countries where there is still room for rate cuts, such as Turkey,” said Hartnett.
One country that has already reaped rewards from the combination of a current account surplus and monetary easing is Brazil, where the benchmark Bovespa index is up 37% since the China-induced sell-off in February 2007. Investors are now net 75% overweight in the Merrills survey, and although this is already lower than 93% in June, Hartnett believes the market could be due a correction.
“In developed markets, investors are overweight the cyclical tech stocks, but these are still a net underweight in emerging markets, so there could be room for investors to switch into the key countries for these stocks, such as Taiwan,” Hartnett concluded.