Emerging-market rally fizzles out

It began with the frothy market in US junk bonds, the higher-yielding debt issued by low-rated companies that has been one of the most coveted asset classes since the US Federal Reserve launched its ultra-loose monetary policies in 2009.

In the past month, US high-yield debt funds have suffered record outflows, investors withdrawing a whopping US$7 billion last week alone, according to JP Morgan.

Now the nervousness is spreading to emerging markets, which have enjoyed a five-month rally following a sharp sell-off in January.

For the first time in over four months, fund flows to emerging market bond funds turned negative in the week to August 6, with nearly US$655 million in redemptions by retail investors, in particular mutual funds based in the US and Europe.

Foreign investors are still increasing their holdings of local currency bonds in many markets

Over the past month, spreads on US dollar-denominated emerging market bonds over 10-year US Treasuries, as measured by JP Morgan's benchmark emerging market government bond index, have risen 43 basis points, undoing nearly all the tightening since the beginning of this year.

Emerging Europe has borne the brunt of the sell-off - mainly because of concerns about the East-West standoff over Ukraine. Yields on 10-year local currency Russian, Turkish and Hungarian bonds have risen 100, 80 and 75 basis points, respectively, over the past three weeks.

Emerging Europe's equity markets, moreover, have been underperforming those in other emerging markets, falling nearly 8 per cent over the past three months.

Respondents to the latest Bank of America Merrill Lynch global fund manager survey now view the rapidly deteriorating geopolitical environment as the biggest "tail risk", while two-thirds of those surveyed expect the Fed to start raising interest rates before the end of the first half of next year.

The big question is whether the marked increase in volatility and risk aversion over the past month will be short-lived or is the start of a broad-based, and potentially disorderly, repricing of risk assets. The jury is still out as to whether the rally in emerging markets is going firmly into reverse.

The recent strengthening of the dollar - up 2.5 per cent against the euro since July 1 - is clearly weighing on emerging market foreign exchange and local currency debt markets. That as many as 85 per cent of respondents in the fund managers survey expect the dollar to strengthen further in the coming months augurs badly for sentiment towards developing economies.

However, there is little evidence so far that the deterioration in sentiment is driven by concerns about assets per se. Latin American stocks have even risen 1.4 per cent over the past month, while emerging market equities as a whole have fallen only 0.4 per cent. This compares with declines of 2.4 per cent for both euro zone and Japanese stocks.

Emerging market currencies have fared worse, but there are significant differences between and even within regions. Asian currencies, notably the Indonesian rupiah, have proved fairly resilient over the past month. Indeed, even within the troubled emerging Europe region, the Turkish lira is down just 2.3 per cent against the dollar since mid-July.

Foreign investors are still increasing their holdings of local currency bonds in many emerging markets. Bank of America Merrill Lynch says Hungary still managed to attract US$100 million in the week to August 1, while Mexico drew US$800 million in the week to July 25.

While the renewed outflows last week are concerning, it's too early to say whether this is the start of another period of sustained redemptions. Even if it is, a key feature of the summer 2013 and January 2014 sell-offs was the "stickiness" of institutional money in bond markets. The large outflows from emerging market debt markets stemmed almost entirely from redemptions by retail investors.

Institutional investors, on the other hand, have continued to purchase emerging market bonds. Local institutional investors, in particular, continue to provide a reliable and stable source of demand, making emerging market assets much more resilient to a deterioration in market conditions. This is partly what helped avert a full-blown emerging markets crisis last year.

Nicholas Spiro is managing director of Spiro Sovereign Strategy