Investor enthusiasm starting to leave emerging markets with that frothy feeling
The last time investors held such an overweight position in emerging markets was at the start of 2013, says JPMorgan, but analysts this time are more positive there is no risk of a full-blown bubble any time soon
The signs of overexuberance and frothiness are all too apparent.
The Mexican peso, which plunged nearly 20 per cent against the US dollar last year and was the biggest casualty of concerns in financial markets about the implications of a Donald Trump presidency, has surged 13.5 per cent this year and is the world’s best-performing currency.
Turkish stocks have risen a staggering 27 per cent this year after having proved extremely volatile in 2016 as a botched military coup led to a fierce crackdown and a further escalation in political risk.
Argentina, a serial defaulter on its sovereign debt and a country with a “junk” credit rating, last week managed to get international investors to lend it US$2.75 billion for the next 100 years at a yield of less than 8 per cent.
Make no mistake, emerging markets are on a roll.
Investor sentiment has not been this bullish since the months leading up to the so-called “taper tantrum” in the summer of 2013 when the unexpected decision by the US Federal Reserve to begin winding down its programme of quantitative easing triggered a sharp sell-off in developing economies.
According to JPMorgan, the last time investors held such an overweight position in emerging markets was at the start of 2013.
Last month’s global fund manager survey by Bank of America Merrill Lynch showed a net 41 per cent of investors were overweight in emerging-market stocks, the highest level since the end of 2012.
Fears of another bubble in emerging markets are growing.
Argentina’s “century bond” has quickly become a focal point for commentary by investment strategists warning of the excesses of financial markets.
In a note last week, JPMorgan claimed that the withdrawal of monetary stimulus by central banks, in particular the Fed, was “likely to lead to market turmoil and a rise in volatility and tail risks”.
Given that the current surge in demand for higher-yielding emerging-market assets is mainly driven by the extremely low, and in some cases negative, bond yields in developed markets, which stem from central banks’ ultra-loose policies, the threat of a tightening-led correction in emerging-market asset prices should not be underestimated.
The most conspicuous case of overstretched valuations in emerging markets is in corporate debt markets.
Spreads, or the risk premium, on the bonds in JPMorgan’s benchmark emerging-market corporate bond index are now almost on a par with their post-financial-crisis lows reached in February 2011 and are only about 20 basis points higher than their lowest levels since the index was launched in 2007.
Asian corporate debt, moreover, has already entered bubble territory.
Spreads on the Asian component of the index, which accounts for nearly 43 per cent of the gauge, are now more than 40 basis points below their tightest levels set in mid-2014, according to data from JPMorgan. The highest-quality high-yield, or non-investment-grade, Asian corporate debt has been trading at similar levels to its US equivalent since early 2016.
Still, a bit of perspective is in order.
The surge in inflows into emerging markets only began at the start of this year, in stark contrast to 2013 when foreign capital had been gushing into developing economies for several years in a row, resulting in a sharp and disorderly sell-off when sentiment turned abruptly. Investor positioning in emerging markets is now at considerably lower levels, reducing the scope for an exodus of capital.
Just as importantly, while there has been a sharp increase in inflows into emerging markets through exchange-traded funds – popular investment vehicles that track an index and allow investors to buy and sell at any time of the trading day, thereby exacerbating sell-offs – long-term institutional investors, such as domestic pension funds and insurers, hold the bulk of emerging-market debt.
This provides a much more stable and secure source of demand during periods of severe stress.
Thirdly – and the most compelling reason to remain bullish on emerging markets – equity valuations have become a lot more attractive following a five-year bear market.
Although having risen significantly since early 2016, developing market shares are still 17 per cent cheaper than in 2011 and were described by Research Affiliates, a fund manager, as the “trade of a decade” earlier this year.
Based on a cyclically adjusted price-earnings ratio – a more accurate valuation gauge that looks at average earnings over a 10-year period – emerging-market stocks are nearly 50 per cent cheaper than their US peers.
Corporate bonds may be looking frothy, but there is no risk of a full-blown bubble in developing markets any time soon.
Nicholas Spiro is a partner at Lauressa Advisory