EM assets lose favour on fears of slowing Fed QE

June 3, 2013 4:10 pm

EM assets lose favour on fears of slowing Fed QE

By Robin Wigglesworth and Alice Ross

Nowhere did recent hints that the US Federal Reserve could cut back its bond-buying in the near future reverberate as loudly as in emerging markets.

Although the bond and stock markets of developing countries have rallied over the past decade on the back of fundamental fiscal and economic improvements, gains have recently been supercharged by the aggressive ‘quantitative easing’ of western central banks – primarily the Fed.Therefore, when Fed chairman Ben Bernanke indicated that the central bank’s $85bn-a-month asset purchases could slow if economic data improved, a US Treasury sell-off and rising US dollar quickly echoed inemerging markets.

Local currencies wilted against the dollar, and many EM stock markets tumbled. Even EM bonds, one of the most resilient asset classes in the post-financial crisis landscape, took a pummelling.

“This is one of the most interesting times for the emerging markets world in a long time,” says Simon Lue-Fong, head of emerging market debt at Pictet Asset Management. “Since 2009 we’ve lived in a world where EM assets have almost been a safe haven.”

The MSCI Emerging Markets index slid for a third straight week; the EMBI Global index of dollar-denominated EM bonds lost 2.1 per cent – the biggest weekly decline since September 2011 – and the equivalent gauge for local currency bonds shed 4 per cent.

Few currencies held their ground against the US dollar. Even the Mexican peso, one of the darlings of Mayfair and Wall Street for months, has lost 6 per cent in the past month. That makes it the second heaviest EM loser after the South African rand, which has dropped by 11 per cent.

“I think this is a wake up call,” says Dagmar Dvorak, currency and fixed income investor at Barings, which has reduced its exposure to the Mexican peso, the Polish zloty and the South Korean won. “Emerging markets are not a one-way bet.”

Fund managers and strategists are now questioning if the Fed is truly ready to startdraining its punch bowl, and whether that will mean the end to a remarkable run for bonds and stocks in the developing world.

EM fixed income is particularly exposed to a less accommodative Federal Reserve. While equities may gain if US growth accelerates, dollar-denominated international EM debt uses US Treasury yields as a benchmark, and loses value if they rise. And local bonds suffer when domestic currencies lose value against the dollar.

The severity and uniformity of the sell-off in EM assets have caused some analysts to conclude that a central bank-fuelled bubble is about to be pricked.

“I am now throwing in the towel,” Benoit Anne, a Société Générale strategist, said in a note. “We are no longer bullish on EM.” Mr Anne said hedge funds have led the retrenchment, and speculated that if big institutional asset managers change their minds on developing markets it could spell “another massive wave of correction”.

Although currencies and bonds were the worst-hit, equities have long been under pressure from slowing economic growth – a factor that is even more important than Fed policy, argues Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management.

“Growth has been quite disappointing,” says Mr Sharma, author of Breakout Nations, a book on new emerging markets. “What started out as a China slowdown is now happening everywhere.”

Investors are clearly becoming nervous. Emerging market equity and bond funds tracked by EPFR Global last week suffered their biggest redemptions since late 2011 and the second quarter of 2012 respectively.

But for now, a painful correction has not yet become a rout. The international and local bonds of developing countries took a beating, but on the whole, emerging market borrowing costs are not far from record lows. And the spread over Treasuries remains subdued.

“The jury is still out, but there’s a long-term secular story of investors diversifying into emerging markets that I think still holds,” Mr Lue-Fong argues.

His funds have become more defensive, but are considering buying more “high quality” hard currency bonds on the expectation that they will recover quickly. Similarly, Ms Dvorak of Barings says the Mexican peso is once again becoming attractive.

The stock markets of the bigger emerging markets have long been disappointing, and many smaller bourses – such as the Philippines – are still near record highs. Frontier markets remained resilient last week, and chalked up their biggest collective weekly gain since mid-2011.

“For many markets this is only a catch for breath,” Mr Sharma says. “Some countries will continue to do well, and some will not.”

Many fund managers and analysts are also pinning their hopes on a fresh bout of stimulus from Japan, even as the Fed considers cutting back on its quantitative easing. HSBC’s Steven Major predicts $600bn of bond outflows from Japan over the next two years, which he argues will benefit emerging markets such as Mexico, Turkey and Malaysia in particular.

Meanwhile, emerging market currencies remain highly sensitive to developments in the US. The dollar fell heavily against most emerging market currencies on Monday after negative figures on the US manufacturing industry sparked concerns over the US economy again. The day of reckoning for emerging markets could come later than some investors fear.