Let's face it: US equity markets are not so attractive these days with sundry subprime minefields and, more visibly, the weakening dollar which has again plunged to all-time lows. Floyd Norris recently noted that, on a USD basis, US equity markets ranked 78th out of 83 worldwide in their performance from 2002 to 2007. Faced with subprime insecurities and dollar debasement, savvy investors appear to have set their sights on emerging markets--the new safe havens which are supposedly far away from the subprime mess and dollar debauchery. Whereas the Asian financial crisis resulted in a boost for US bourses at the expense of emerging Asian bourses as investors piled into the former and fled the latter, what we have now may be just the opposite. Recent Treasury capital flows data may indicate the beginning of capital flight, US-style.Welcome to the brave new world of high finance. Still, questions linger over whether investment in emerging economies is just a passing fad or a long-term phenomenon. We'll have to wait a while before rewriting those finance textbooks. From the Financial Times:
As problems welled up for western finance this summer and the global credit squeeze took hold, emerging markets were initially jumpy. But then something remarkable began to happen. In the last few weeks, international investors have piled in to buy assets from developing nations, scooping up everything from Brazilian bonds and Chinese shares to the South African rand.
The rush has become so marked that some analysts have started to talk about a once unimaginable idea: that buying securities in a country such as Indonesia or Chile could be an appealing opportunity when there is a “flight to quality” under way. Emerging markets, in other words, have started to resemble a safe haven.
Emerging market assets used to be viewed as highly risky investments suitable for only the bravest of investors. The Asian financial crisis and Russia’s default on domestic debt a decade ago came as cautionary tales. Indeed, some suspect this latest burst of enthusiasm is nothing more than a whim that will disappear when confidence in US and European markets returns.
But others wonder whether there is a more profound structural shift under way. The rise of emerging markets has gone hand in hand with a recognition that countries such as China, India and Russia are likely to play an increasingly key role in the growth outlook for the world in coming years.
Some of these cash-rich economies also wield unprecedented clout in the global capital markets. The map of the modern financial ecosystem is shifting in the heads of the world’s investing class and emerging markets are no longer relegated to the periphery.
“Emerging markets are driving world growth and are shifting the centre of gravity of the world economy,” says Christian Deseglise, head of emerging markets at HSBC Investments, part of the UK-based bank. “What has changed is investor perception of emerging markets. The fact that emerging markets may be less of a source of risk than the developed markets is increasingly being recognised by investors.”
The volume of money that has flooded into the sector in recent months – even amid the wider credit squeeze – is dramatic. Brad Durham of EPFR Global, which tracks fund flows, says that of the $29bn (£14bn, €20bn) in net inflows to emerging markets so far this year, 82 per cent has arrived over the past seven weeks, “which is astounding”.
By contrast, during the same period, US equity funds tracked by the group saw outflows of $6.3bn, European equity funds (excluding east European funds) surrendered $6.9bn and Japanese equity funds gave up $3.9bn.
Rallies in Asian stock markets have been particularly heated, and not just over the last few weeks. China’s Shanghai Composite stock index this week broke through 6,000 points for the first time, while in India the Bombay Stock Exchange’s Sensex index crossed the 19,000 mark, also a first. That leaves the Shanghai Composite up 420 per cent since the beginning of last year, the Sensex up 99 per cent and Hong Kong’s Hang Seng index up 97 per cent.
The MSCI Emerging Markets index has risen by one-third since August 18, the day the US Federal Reserve cut the rate at which it lends to banks – far outperforming developed markets. Indeed, emerging market equities are now at a premium of about 10 per cent to developed market equities based on historical valuations, according to Jonathan Garner, global emerging market equity strategist at Morgan Stanley. Even so, he says, valuations are below previous peaks and earnings growth expectations are significantly above those in developed markets.
Analysts are divided on the sustainability of this exuberance, some seeing it as a flight to safety and others as the beginning of a new speculative bubble. Nonetheless, investors’ new-found confidence in emerging markets does reflect one reality, namely that many emerging economies are in far better shape than ever before to weather broader financial turmoil.
Many are commodity exporters and many commodities are at record highs. Crude oil on Wednesday soared to a fresh record of $89 a barrel, while the Rogers International Commodity index – which tracks oil and non-energy commodities including coffee, soyabeans, wheat and corn – has gained more than 25 per cent so far this year.
Additionally, over the past five years, many emerging market governments have taken steps to insulate themselves from the effects of a global financial crisis. Scarred by the effects of the crisis in Latin America in 1982, the so-called “tequila crisis” in 1994-95, the Asian contagion in 1997-98, the Brazilian crisis in 1999 and Argentine upheaval of 2001, many governments have taken advantage of the recent period of strong global growth and low interest rates to husband resources rather than spend them. Many have been paying off public debt, are running budget and/or current account surpluses and have built strong foreign exchange reserves.
While high debt was a source of vulnerability to crises in the past, emerging markets as a group are about to become net creditors for the first time, with international reserves of developing economies set to surpass the amount of foreign debt they hold.
The improvements in their economies have attracted a more diverse group of investors – including pension funds, central banks and local investors – which analysts say are increasingly investing for the long term. “Many investors have stayed put during the summer turmoil and hesitated to take profits during the following breathtaking rebound,” says Beat Siegenthaler, senior strategist at TD Securities in London.
Also contributing to the activity is China’s recent decision to lower barriers that prevented its pension funds, investment trusts and individual investors from investing abroad. As a result, the mainland’s own stock market frenzy, driven largely by domestic retail demand, has spilled over into Hong Kong. Regulators are also giving more Chinese funds permission to invest abroad under the qualified domestic institutional investor scheme (QDII). [It's a bit strange, but the Hong Kong Stock Exchange is not treated as a "domestic" market in China.]
Jing Ulrich, head of China equities at JPMorgan Securities, expects $90bn in QDII funds to leave China in the next year, with at least one-third heading for the Hong Kong stock market. “As Hong Kong’s market rises on the back of increased flows from China, other Asian markets will look cheap in comparison. Thus the ‘China factor’ has both a direct and knock-on effect on Asia-Pacific equities,” she says.
Yet despite all the optimism, few expect volatility in emerging markets to be a thing of the past. Certainly they are not immune to a broad retreat by investors: in the wake of the US subprime mortgage crisis, prices of emerging market assets initially fell sharply, along with many others, before the rally resumed.
The sudden huge inflows have also raised fears among some investors and emerging market governments alike that the euphoria is a bubble in the making, which some commentators have compared to the technology-led boom of the late 1990s and which could be punctured if the US economy shows signs of slowing sharply.
Emerging countries themselves retain the ability to spring unwelcome surprises. On Wednesday, the Indian authorities’ proposal to impose restrictions on inflows into equities by non-residents – aimed at curbing appreciation of the rupee and taking some froth off the stock market – triggered a fall in both the currency and shares. “India is unlikely to be the last market to use direct controls on inflows,” says Philip Poole, head of emerging markets research at HSBC.
Some investors are convinced that economies in the rest of the world have become decoupled from the US – that even if the US economy slows, the rest of the world, particularly the fast-growing emerging markets of China and India, will not. In its World Economic Outlook, released on Wednesday, the International Monetary Fund says world growth is expected to slow but remain solid, supported by the strong momentum of the main emerging markets. China, India and Russia together “accounted for one-half of global growth over the past year”, it observes. [Wow!]
Peter Eerdmans of Investec Asset Management says: “There is certainly reason to believe that emerging markets, which are now a much bigger part of the economy than in the past, will be able to decouple from this slowdown, at least to some extent... However, to say that they will be immune is very dangerous. A huge percentage of global exports still ends up with the US consumer.”
There are also fears that the credit squeeze could bring more trouble. “Investors are buying into the idea of decoupling economies and sustained strength of commodity markets,” says David Bowers, managing director of global strategy at Absolute Strategy Research, a London-based consultancy. “But this kind of financial turbulence is completely outside everyone’s experience. We have seen things in the last 90 days that we never thought we would see in our entire financial careers. Some credit lines have closed that may never reopen again. To think that this will not leave some permanent mark on the financial markets is hard to comprehend.”
The spectacular rebound in emerging market assets – which was given a huge boost last month when the Fed slashed its main interest rate by half a percentage point – has prompted parallels with the monetary easing undertaken during the credit market crises of both the late 1980s, following the economic turmoil in Latin America, and of the late 1990s, amid the Asian and Russian upsets. Those led respectively to bubbles in Japanese equities and global technology stocks, analysts say.
Ed Yardeni of Yardeni Research says: “Financial panics have always been wonderful buying opportunities, as long as they didn’t cause a recession and a financial meltdown. Indeed, they sometimes even set the stage for great bubbles, which were hugely profitable until the bubbles popped. This scenario may be on replay now, especially in Asia.”
Moreover, some analysts believe that the risk premiums being paid to investors for holding many emerging market bonds – which are now back to their mid-July levels before the sell-off – are too low. “At current levels, many emerging market bond valuations look stretched, leaving them vulnerable to an additional deterioration in global credit conditions,” says Mr Poole.
Some emerging economies remain vulnerable to difficult credit conditions. Strains have already been revealed in Kazakhstan and in several economies in eastern Europe. This raises concerns that some investors have been buying emerging market assets without properly weighing the risks.
The biggest unknown, however, is what impact a sharper than expected US slowdown would have on emerging markets, particularly in Asia. Stephen Roach, chairman of Morgan Stanley Asia, says that if US consumer demand falls, “Asia will be hit hard”, though unevenly. “A rapidly growing Chinese economy has an ample cushion to withstand such a blow... Other Asian economies, however, lack the hyper-growth cushion that China enjoys. As such, a US-led slowdown of external demand could hurt them a good deal more.”
Mansoor Dailami, manager of international finance at the World Bank’s development prospects group, says the world is “rebalancing” rather than decoupling, which is positive. “But the Chinese economy is not large enough to substitute for the US.”
That is why some market watchers think that investors’ increasing faith in emerging markets could be betrayed. Michael Hartnett, chief global emerging markets equity strategist at Merrill Lynch, says: “The risk of an investment bubble in emerging markets is very high. Every decade has seen a strong bull market mutate into a mania phase – and emerging markets look the prime suspect this time around.”
