An emerging market, according to the old joke, is one that you cannot emerge from in an emergency.
Whether recent events constitute an emergency or just a drama, it is clear that a great deal of emerging has been going on. According to the Institute of International Finance (IIF), foreign investors reduced their holdings of emerging market portfolio equity in six of the past 10 months, resulting in a total retrenchment of $12bn.
Last week alone saw an exodus of $6.3bn from equity funds on the estimate of data provider EPFR. What we saw in January was an old-fashioned flight to quality – witness the fall in 10- and 30-year US Treasury yields last week – and a return to the knee-jerk world of risk-on/risk-off trading. Who is to blame for this dismal start to the market year?
All fingers point to the Federal Reserve, which last Wednesday acted to further reduce its bond purchasing programme. Yet the Fed’s announcement of more tapering was widely expected.
The underlying problem was surely that there was a near-consensus on January 1 that 2014 was going to be a good year for global equities despite their considerable run up last year. The market was overblown and vulnerable, with Japan being the most extreme case in point. After the 57 per cent stock market rise last year, Japanese equities have shown by far the worst performance among the major markets in January.
The difficulty for emerging market equities, which are down considerably more than those in the developed world, is that they ran into a barrage of specific bad news: a weak purchasing managers’ report from China; strikes in South Africa; political crises of varying degrees of severity in Ukraine, Turkey and Thailand; Argentina retreating into yet another devaluation, and so forth. Against the background of Fed tapering, which means that global liquidity conditions are tightening, those countries with current account deficits and large external financing requirements are inevitably feeling the strain.
How long will it take for emerging markets to stabilise? In the latest of its regular research notes on capital flows to emerging markets IIF is relatively upbeat. While acknowledging that investors have become more sensitive to country risks, it argues that there will not be a sustained pullback from emerging markets. Its prognosis is for a gradual rebound in capital flows in 2014 and 2015, although at a much lower level relative to gross domestic product than from 2010 to 2012, on the back of a sustained pick-up in global growth and a gradual Fed exit from bond buying.
I am not so sure, however. The markets’ negative response to central bank tightening last week in Turkey, South Africa and India suggests that investors may feel that the level of real interest rates in the developing world are simply too low and that the risks are higher than previously thought. If rates are going to rise significantly, that will eat into the emerging markets’ growth story. Investors are also increasingly wary about currency risk, which is bound to be tricky to manage while the Fed tapers and eventually starts to raise rates. There is a question, too, about whether the emerging market asset category is due for a more general reassessment.
The past 12 months have served as a potent reminder that political risks in the developing world are too readily underestimated. The speed with which Turkey has gone from being an exemplary democracy to one where governance is increasingly wayward has been an object lesson on how political risk can take investors by surprise. Much of the economic and financial case for emerging markets has also come adrift as a result of the global flood of liquidity unleashed by developed world central banks.
After the Asian financial crisis many emerging market countries responded by accumulating mountainous quantities of foreign exchange reserves and reducing reliance on foreign currency debt. National balance sheets were tidied up and good housekeeping prevailed. Yet the tidal wave of capital inflows led in some countries to renewed current account deficits, rising inflation and a return to foreign currency borrowing.
At the same time China is no longer helping the developing world’s commodity producers as it slows down and tries to shift the balance of its economy away from investment towards consumption. And as we saw again last week, the movement of share prices across the world tends to become more closely correlated when markets become twitchy, so emerging markets are not offering the portfolio diversification that investors looked to them to deliver.
No doubt there are bargains to be had, but a more general recovery is not yet, I suspect, in the offing. My guess is that the flight to US Treasuries will be temporary and that this nervous money will soon find a home in developed world equities.
Get alerts on Markets when a new story is published