End of an era for emerging market credit?
The violent synchronized sell-off in emerging market assets – across FX, local rates and credit – raises the spectre of a new normal: the end of unsustainably high foreign ownership of assets, particularly local currency credit, greater credit differentiation and the waning power of financial repression in the US as a fillip to EM flows, bearish analysts say.
It’s the end of the unsustainable love affair for emerging market (EM) credit, bears contend, after last week's rout exposed a new normal: tighter monetary conditions in the US, which raises the spectre of slower inflows into emerging capital markets.
For bears, the jury is out about the time-scale of any unwind from pockets of EM credit and how messy the break-up could be, while the optimists point out, though positioning is high by historic standards, emerging markets can withstand the recent volatility thanks to their strong growth prospects. The high degree of volatility is causing concern as funds confront paper losses, value-at-risk challenges, event risks – amid protests from Brazil to Turkey, for endogenous reasons – and febrile market sentiment as investors awaken to the Fed’s tapering of its bond-buying plan by year-end.
Most EM currencies have fallen against the US dollar in recent weeks while US Treasury yields have risen, attracting funds back to the US. The South African rand, Mexican peso, Brazilian real and Indian rupee have been hit in particular.
An additional factor aggravating volatility this time around is the current-account deficits many emerging economies are running. This external financing requirement makes them vulnerable to currency shocks and any slowing of the capital inflows that sustain their current-account deficits.
As yet it is unclear whether currency depreciation is a symptom or a cause, but much of the unwinding of positions in debt markets has been from local currency bonds, exerting downward pressure on currencies.
Redemptions from EM bond funds topped $2.53 billion in the week ending June 14, the second-largest outflow on record, according to EPFR Global.
With investors facing currency risk and local bond market risk, it is only a matter of time before the prospect of an era of higher yields in the developed world against EMs’ weakening economic fundamentals begins to make itself felt.
The question is how much time, given that the US Federal Reserve has done nothing – and even if it substantially moderates the pace of quantitative easing (QE) next year, higher interest rates could still be years away.
George Papamarkakis, chief investment officer at North Asset Management, says rising Treasury yields are just the catalyst and there are other deeper underlying causes for EMs being buffeted by a toxic combo of “exceptional volatility” and record-low liquidity, though hard currency bonds could outperform.
“In the 15 years-plus I’ve been looking at these markets, I’ve never seen anything like this,” he says. “In terms of local government bond markets, which is where the largest investor positioning is, volatility and liquidity are the worst they’ve ever been in the history of emerging markets.
“Over the past decade or so, local currency has become a dedicated asset class with about $230 billion of real institutional and retail money but the reasons for the original investment – higher nominal and real yields and superior fundamentals – are no longer justified in many of the core emerging markets.”
He adds: “They’ve had an incredible return-run and they need to ask themselves: ‘Should I be long these local markets based on today’s fundamentals rather than based on the fundamentals I invested in five years ago?’
“The resounding answer to that is ‘no’ because the fundamentals are not great because some of the very big markets, such as Turkey, South Africa and Brazil, are now running current-account deficits, real yields are negative in many of these countries and nominal yields are quite low.
“The reason the current volatility is so worrying is that there’s a huge imbalance between the size of the positioning and the potential liquidity on offer at exit. We have extreme positioning – some government bond markets are up to 50% owned by non-residents – versus pretty poor real economic flows.’’
Economies with the largest percentage of foreign-owned bond markets include South Africa, Hungary, Turkey and Malaysia.
|Source: Emerging Advisors Group
With these metrics, the concern is who will be the buyers if foreign investors decide to start liquidating. Most EMs, with the possible exception of South Africa, lack a deep domestic institutional base – insurance companies, banks, pensions and mutual funds – to absorb the other side of an unwind. The redemption challenges for real-money managers is a big unknown because, in many cases, it depends on the untested risk tolerance of retail investors.
The prospects for an orderly withdrawal are bolstered by the fact that large institutional investors, which hold the largest allocations, are long-term investors and might take weeks, if not months, to decide on any re-allocation.
However, Pimco’s $285 billion Total Return Fund, which went from 2% to 3% invested in EM local bonds in 2009, has reduced its EM holdings by 1% to 7% between April and May, according to one fund manager in London. Pimco could not be reached for comment.
Non-Japan Asia might fare better because its economies have not undergone the consumer credit boom on the scale seen in other EMs, their current accounts are in surplus and currencies are lower, according to the IMF.
Non-residents’ positions in their bond markets are also smaller.
Guy Foster, head of portfolio strategy at Brewin Dolphin, is sceptical that the increase in Treasury yields is sufficient to trigger wholesale allocation of big tranches of capital from EM bonds back to developed market bonds but says it’s likely to be the shape of things to come.
“From here on in, the unwind of the emerging market trade is going to be driven by the same sort of factors which drive the reduction in the pace of purchases by the Federal Reserve: namely the strength of US economic data,” he says.
“It’s not going to happen particularly dramatically or quickly, but it’s hard to imagine you’re going to move back into a secular bull market for emerging market currencies with that spectre [the withdrawal of QE] constantly hanging over the developed markets.”