The emerging markets investment theme continues to sit at the forefront of any investment debate. In a world where the developed markets are going through an extended period of low growth, deleveraging and public finance crises, emerging markets look to promise a high-growth alternative for investors.
However, it is important to look under the hood of these headline arguments. It is true that emerging markets offer positive long-term prospects. The idea of convergence is well supported theoretically (albeit in practice, the evidence is mixed). But as investors, we must not only look at the potential higher return but also the time and the path it takes to get to that return. And while it is a bit of an incorrectly coined term, for emerging markets the predominant theme seems to be “long-term alpha, short-term beta.”
Rogoff and Reinhart have argued extensively that history shows countries in the periphery have not been immune to the shocks emanating from the center. While in the initial wave of the recent market woes, the EM markets sat relatively tight compared to the developed markets, they’ve lost ground recently, as evidenced by sharp currency and equity market moves.
While EM is not just one homogenous group, especially with stark differences between the characteristics of the countries among different geographies, there are several underlying factors that cause the anchor with the developed world. Firstly, EM countries do not live in a vacuum. Their growth phase is underlined by significant imports of capital to fuel growth. Therefore, they feel the heat very closely when the funding markets are under stress. The basket of EM currencies as well as the spreads have been moving higher sharply recently which is a signal that the funding problems in the developed world are is spilling over.
The situation poses the risk of a further negative feedback loop as the unwinding of existing positions primarily driven by hedge funds and banks put more pressure on the exchange rates, which result in further sell-offs. With an estimated $1.5 trillion of external funding needs, according to some estimates on the Street, the funding issue will continue to be the elephant in the room, and will trump any long-term fundamental arguments for the EM world. And there is no respite as long as the developed market woes (eurozone crisis, laconic growth) continue to occupy the agenda.
Furthermore, the situation is not something EM can be weaned off of quickly. We see that, except for Asia, the net foreign liabilities of emerging markets continue to fluctuate around 20-30% of GDP. The banking systems continue to rely on wholesale funding as loan-to-deposit ratios hover around 100%. Also, with relatively high developed market foreign ownership of the banking system, it will not be easy to adjust the funding situation. Even the relatively safer commodity-driven EM countries are not completely immune to the situation as the financial duress has now spread to the commodity markets.
The recent sell-off has not pushed the emerging markets into an oversold territory either. The EM funds continue to see net inflows predominantly driven by continued institutional allocation. This continues to keep the sales limited mostly to those who are more overextended. Therefore continued volatility and the ensuing lower returns could result in a reassessment of allocations, which will remove the cushion that has existed up to now.
This feedback loop poses a large risk as poor performance results in capitulation which drives further bad results. In fact, hints of this can be seen in the bond market, which initially did not see absolute price declines amidst increasing spreads, because it was the treasury yields coming lower. However, recently spread increases are driven by rising EM bond yields, pointing to selling in riskier EM names. Therefore, watching the flow of investment is another key factor.
Undeniable as the long-term arguments may be, the tipping point and the ensuing moves will be quite sharp in the short run if the funding problems continue. Therefore the investor should be careful before jumping on the emerging market bandwagon too quickly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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