Emerging market bulls sound quite bearish
Are investors in emerging markets suffering a bout of schizophrenia?
Judging by the performance of emerging market assets this year, there are scant signs that international investors are worried about the asset class.
According to data from JPMorgan, net inflows into emerging market equity and bond funds since the start of this year have reached nearly US$170 billion, putting them on track to exceed the record level of US$185 billion for the whole of 2010. The MSCI Emerging Market Index, the main equity gauge for developing economies, has surged nearly 30 per cent - compared with a 15 per cent rise for the benchmark S&P 500 index - while spreads, or the risk premium, on emerging market corporate debt (as measured by JPMorgan’s corporate emerging market bond index) have fallen to their lowest level on record.
In the latest sign of the fierce demand for higher-yielding assets, China sold US$2 billion of 5 and 10-year dollar-denominated debt - the country’s first dollar bond issue in more than a decade - to mostly foreign investors last Thursday at yields of just 15 to 25 basis points above benchmark US Treasuries.
Yet scratch the surface of investor sentiment towards emerging markets and a less reassuring picture emerges.
At an investor seminar hosted by JPMorgan at the annual meetings of the International Monetary Fund and the World Bank in Washington earlier this month and attended by more than 1,000 institutional investors, views on emerging markets were decidedly mixed.
In a client survey on the day of the seminar, nearly half the respondents said they held a “long”, or overweight, position in emerging market currencies and local bonds which they intend to maintain. Less than 5 per cent held a “short”, or underweight, position. Moreover, nearly 50 per cent of respondents believed that spreads on emerging market dollar-denominated bonds will more or less remain at their current levels in a year’s time, while nearly a quarter said they will tighten further.
Yet despite their bullish positions in emerging market assets, the investors are increasingly worried about the external factors that have been buoying sentiment towards developing economies.
Not only do the bulk of the respondents (roughly 70 per cent) believe a tightening in monetary policies by the world’s main central banks poses the biggest threat to emerging markets, the vast majority believe the Federal Reserve will raise interest rates between three and four more times by the end of next year - more or less in line with the Fed’s own projections and a significantly more bearish stance than what bond markets are currently pricing in.
More strikingly, nearly 70 per cent of investors believe emerging market currencies, which have risen sharply this year due to the plunge in the dollar, will decline or remain flat against the greenback next year. Moreover, in a sign of the extent to which investors are increasingly concerned about stretched valuations in emerging market corporate debt markets, Asian investment grade and high-yield, or “junk”, bonds are now the least favoured segment of the market, accounting for more than 40 per cent of the geographic areas where investors plan to reduce their exposure.
Lastly, and perhaps most tellingly, a slowdown in China’s economy due to a tightening in monetary policy represents the biggest emerging market-specific risk according to 70 per cent of respondents, a view that contrasts markedly with the lack of concern in markets about the severe vulnerabilities in China’s economy.
So why are emerging market investors sounding bearish yet maintaining their bullish positions?
The disconnect is not as odd as it appears.
Emerging markets have been on a tear this year and it stands to reason that investors are questioning the sustainability of the rally. Inflows into emerging market funds have already slowed over the past several weeks, with local currency debt funds suffering outflows and a sharp drop in inflows from speculative exchange traded funds.
More importantly, sounding bearish is one thing. Taking bearish positions in quite another. With the global stock of negative-yielding government bonds still amounting to over US$9 trillion, demand for higher yielding emerging market assets remains strong, regardless of concerns about China and the Fed.
Thirdly, global financial conditions remain easy because of extremely accommodative monetary policies, with the Fed hiking rates gradually and aggressive quantitative easing in Japan and Europe.
Still, emerging markets are acutely vulnerable to a sudden and sharp deterioration in sentiment and, according to the IMF, would be “disproportionately affected by [a] correction in risk assets”, potentially suffering up to US$100 billion in outflows in the first four quarters of a correction.
Emerging market investors will find it increasingly difficult to keep ignoring their own warnings.
Nicholas Spiro is a partner at Lauressa Advisory