It was always just a matter of time before the emerging markets experienced some kind of wobble. Last month there was a reduction in risk across most asset classes. Currencies such as the Turkish lira and the South African rand suffered big falls, Latin American bonds sank to one of their lowest levels all year, and mayhem swept emerging equity markets from Brazil to Saudi Arabia to India. The questions now are: is this is a temporary blip or something more substantial, and, if it’s the latter, what picture will eventually emerge?
The immediate reaction is that this will prove to be no more severe than previous recent corrections. For the past two years the emerging markets have suffered a springtime tumble. In 2004, fears of a hard landing in China sent commodity prices lower, leading to a sell-off in emerging market debt. Last year, concerns about US interest rates and inflation had a similar effect. On both occasions the markets more than recovered, with the JPMorgan Embi Plus index heading lower and lower, eventually breaking the 200 basis point barrier in February. Some analysts reckon the fallout this time will prove no different. The Embi Plus is still hovering around the 200bp mark even after the correction while some stock markets, for example, India’s, are beginning to recover their losses. Walter Molano is one economist who reckons that as soon as the emerging debt market bottoms out, investors will pour back in and that the asset class “will soon be cresting through the highs that were posted a few weeks ago”.
That’s as maybe; caution should be the watchword for emerging markets investors over the coming months. Perhaps a more telling indication of what might unfold is not so much short-term market performances as Pimco’s decision to cut the emerging markets allocation in its broader high-grade bond funds to 1% from 2%. Just two months previously, the fund manager was arguing that emerging markets continued to be a compelling investment.
The worry is not so much over the emerging markets themselves. Without doubt, the economic fundamentals in the developing world have massively improved over the past few years, even if the bursting of the commodities bubble is a potential threat. Most countries have large international reserves, low financing requirements and decent levels of growth. Even a perennial laggard, such as Indonesia, is putting its house in order. But with uncertainty over the US dollar and the Federal Reserve’s next move, the global liquidity drain has begun. It might not lead to a full-blown retreat in emerging markets. The asset class, however, is no longer a one-way bet. Interesting times lie ahead.
