The speed with which emerging markets bounced back after the credit crunch is unprecedented, and has alarm bells ringing
Resilience is the word widely used to describe the performance of emerging market assets since the sub-prime crisis exploded this summer.
Credit default swap spreads, equity valuations and high-yielding currencies were certainly not immune from the global financial jitters, but the recovery was swift – and in some cases spectacular. Both the Brazilian real and the Turkish lira appreciated to their strongest levels for the year in September, and the MSCI emerging markets equity index similarly reached new highs in the same month.
Of course, there is a fine line between resilience and exuberance. But even before the US Federal Reserve’s 50 basis point interest rate cut on September 18, Michael Hartnett, global EM equity strategist at Merrill Lynch, was describing the outlook as “1998 in reverse”.
He said: “We remain bullish and think an investment bubble is more likely than a bear market.” The credit problem lies with the US this time instead of Asia, Hartnett argues, so the liquidity unlocked by Fed easing will flow into emerging markets, assuming the global economy avoids an outright recession in 2008.
That, of course, is still a big if. But in any event, the speed of the MSCI’s recovery makes Dariusz Sliwinski, emerging market equity fund manager at Martin Currie, uneasy. “The levels are justified by fundamentals, but the rebound was much too quick: it suggests that some crossover investors, macro hedge funds, have made reallocations outside the US, not dedicated emerging markets people,” he says.
His suspicion is reinforced by the fact that large-cap stocks have outperformed in the rally, implying non-specialist investors who are simply upping overall exposure to EM equities by benchmarking the MSCI. By contrast, mid-cap stocks with more promising fundamentals have underperformed, and this is where Sliwinski is looking for value in the short term.
UC Berkeley economist Barry Eichengreen is also worried about an emerging market investment bubble. “Bubbles occur in environments where there are lots of imperfectly informed investors, where there are lots of new investors not terribly well informed about the facts on the ground who are moving into these markets for the first time, because they’ve been performing so well,” he says. “I worry about that in the context of the stock market in Shanghai and a variety of other contexts.”
Sliwinski stresses, however, that there is in any case no shortage of new money for EM funds. “It is coming from the Gulf, from Asia, but also still from the UK and US. And most US pension funds are still underweight international equity allocations; they have not reached their prudential limits,” he says.
Emerging market currency strength is also understandable, given expectations of slower growth in the US, says Stephen Gilmore, new markets currency strategist for AIG in London and a former IMF economist. In the past, weaker exports to the US tended to mean more bearish sentiment towards EM foreign exchange, but trade among emerging markets themselves has significantly increased, and fundamentals are more robust. “Economic growth is stronger, budget balances are healthier, many emerging markets are running current account surpluses, and even those that are not are self-insuring through the build-up of foreign exchange reserves,” Gilmore argues.
EM debt
For the same reasons, Jerome Booth, head of research at Ashmore Investment Management believes spread tightening on external debt is perfectly natural. “Many of these countries are really a lower credit risk than the US, if you look at their sovereign debt levels and foreign reserves. When the market starts to price that in, then you can talk about valuations becoming stretched,” he tells Emerging Markets.
The investor base in hard currency debt is also increasingly long term, he adds, composed of pension and insurance funds. Money from the more speculative investors, Booth anticipates, will find another home in newer asset classes, avoiding a bubble in sovereign debt. Precisely the reason why, just this month, Ashmore launched a dedicated emerging markets high-yield corporate debt fund, which Booth believes is the first of its kind. “Since the credit crunch, spreads on the conventional EM corporate bond issues have risen by 300-400bp, making that segment more attractive,” he adds.
And, of course, investors are flooding to local market debt, buoyed not only by currency appreciation, but also by the stabilization stories that have helped many emerging market central banks engage in lengthy monetary loosening – which will have further to go if global growth slows. Historically, the transition from foreign to local currency debt financing has been a difficult one for emerging markets, with a shallow domestic bid leaving exchange rates highly vulnerable to foreign funds running for the exits, sometimes for external rather than domestic reasons.
“This is not a problem for countries like Brazil, which now has larger foreign reserves than the US. But some countries are temporarily increasing their vulnerability to external shocks, until they have built a full 30-year local currency curve that is mostly bought by domestic investors. Then their debt financing is invulnerable to external shocks, like the UK,” explains Booth.
Recognizing this dilemma, the World Bank and IFC sought to fill the gap earlier in October, with the announcement of a $5 billion emerging market local currency fund, Gemloc, to act as a stable long-term investor in local debt. The initiative stemmed from an agreement at the G7 finance ministers’ meeting in February this year, and Oliver Fratzscher, a senior economist at the IFC, believes there will be substantial interest from investors.
“There is already $14 billion benchmarked to [existing] local debt indices and more money offshore in forward and derivative markets. For us to put the money into onshore markets will help these countries develop longer government local yield curves, which will then enable more corporate issues, mortgage instruments and the like,” he tells Emerging Markets.
To avoid the risk of Gemloc creating its own bubbles in shallow markets, no more than 10% of the fund will be allocated to any individual country. In addition, the level of investment will depend on how that market performs against 25 investability indicators including market size, liquidity, and whether the country has capital controls or withholding taxes on capital market transactions. This will ensure that investment does not outpace the capacity of the local market to absorb it, as well as inheriting the Brady Plan tradition of directly tying capital flows to market-oriented policies.
The fund’s own fee income will be ploughed back into technical assistance for countries to meet the criteria. Alongside Gemloc itself, the 25 criteria will also be used to formulate a new index, Gemx. JP Morgan already runs its ELMI+ short-term and GBI-EM long-term local currency bond indices, which cover 22 and 19 countries respectively.
But Fratzscher says Gemx will be distinguished by the investability indicators that will help investor decisions, and by its comprehensive coverage. “Many investors tell us they are already fully invested against the existing indices, so they can use the Gemx, which will have 40 countries, to diversify their exposure,” he says.
Sovereign wealth demand
In the medium term, the initiative is intended to foster the development of emerging market institutional investors, as EM-based pension and insurance funds will be granted permission to invest in Gemloc itself. Initially, however, Fratzscher says the leading source of demand is from emerging market sovereign wealth and reserve management funds, which have been keeping most of their reserves in low-yielding US Treasuries.
“China, India, Brazil, the Gulf and Russia – they have provided the main push to do this. Many have suffered negative returns in local currency terms because they are holding US Treasuries while their own currencies appreciate, and they want to invest in a basket of emerging market local currency bonds,” he says.
This provides a revealing insight into the cautious approach of sovereign wealth funds towards raising their risk profile. Investing with a fund created by a multilateral institution specifically for development purposes makes political and economic sense. It might also help to lay to rest some of the fears about large, politically-controlled wealth funds causing alarm and volatility in the markets.
“They are more likely to invest with a longer time horizon than regular institutional investors, to act as a stabilizing influence,” says Stephen Jen, the chief currency strategist at Morgan Stanley, who has been closely watching the emergence of China’s new wealth fund CIC.