Investors run for exits in Emerging Market funds, but institutions stay for now
The outflows from emerging market (EM) funds show no signs of abating.
For those who took the view that the sharp sell-off during the summer of 2013 - when EM assets took a pounding because of the unexpected announcement by the US Federal Reserve that it planned to start winding down, or “tapering”, its asset purchases - was a foretaste of things to come, last week’s dramatic surge in redemptions from EM equity funds is confirmation that developing economies are in for a rough ride once the Fed starts to raise interest rates, possibly as soon as September.
According to EPFR Global, outflows from EM equity funds in the week ending June 10 rose to US$9.3 billion - the largest weekly redemptions since the outbreak of the global financial crisis in 2008. Chinese and Hong Kong-focused funds accounted for 75 per cent of the outflows. A whopping $24 billion has flown out of EM equity funds since the beginning of this year - roughly 80 per cent of the outflows for the whole of 2014.
EM equities are down 3.3 per cent this month compared with a 0.8 per cent fall for the benchmark US S&P 500 index.
More worryingly, EM bond funds - which have attracted more than $9 billion of inflows so far this year - have suffered outflows for the past three weeks, with nearly $800 million flowing out of EM debt funds last week, according to EPFR.
EM currencies are also under renewed pressure, with the Russian rouble, the Turkish lira and the South African rand losing 9.3 per cent, 6 per cent and 5 per cent against the dollar over the past month. Even the resilient Indian rupee has dropped a further 1 per cent, bringing its decline against the greenback since the end of January to 4.5 per cent.
Moreover, the average yield on JP Morgan’s benchmark EM local currency bond index (GBI-EM) now stands at 6.8 per cent, up from less than 6 per cent at the end of January and just 20 basis points shy of its post-taper high in early February 2014.
Make no mistake, sentiment towards EMs has deteriorated sharply over the past few months and has not been this bleak since the nine-month-long “taper tantrum” began in May 2013.
Yet even during the tantrum, the sharp increase in outflows from EM debt funds - which saw net inflows collapse from nearly $100 billion in 2012 to just $6 billion in 2013, according to JP Morgan - stemmed almost entirely from redemptions by flighty retail investors, such as US and European mutual funds.
Institutional investors, on the other hand, such as pension funds and insurance companies, continued to allocate money to EMs and ensured that flows to bond funds remained in positive territory in 2013.
Indeed, as JP Morgan notes, retail money is no longer the “anchor for EM sponsorship”. Local and foreign institutional investors - who take a longer-term view and are much more committed to the EM asset class - now hold the bulk of EM debt, in stark contrast to the 1990s when hedge funds and other opportunistic foreign investors dominated the market.
Any sign that institutional investors – especially domestic ones which hold some 70 per cent of EM debt according to JP Morgan and “play a critical role in absorbing paper that foreign investors and market makers would otherwise be unable to hold” - are exiting the bond markets of developing economies would remove one of the most important pillars of support for EMs and potentially trigger a full-blown crisis.
Yet this is unlikely to happen for several reasons.
Firstly, institutional investors’ allocation to EM bonds is still very low relative to their exposure to developed market debt, providing significant scope for further inflows in the coming years.
Secondly, the unprecedentedly low bond yields in advanced economies have significantly reduced the returns of pensions funds and insurers, forcing institutional investors into higher-yielding EM assets in order to ensure that their returns do not fall short of their liabilities.
Thirdly, the Fed has made it patently clear that it intends to raise rates in a cautious manner and is sensitive - indeed too sensitive - to markets’ reaction to the first tightening in US monetary policy since 2006. On Wednesday, Janet Yellen, the Fed Chair, stressed that policy will remain “highly accommodative” even after the first rate hike, suggesting US borrowing costs will be “lower for longer”.
Volatility remains the watchword for EMs as opposed to a full-blown crisis.
Nicholas Spiro is managing director of Spiro Sovereign Strategy