Hopes that emerging markets might provide a viable alternative to investment in advanced economies have been dealt a blow in the past week, with large withdrawals from fixed-income funds coupled with falling stock indices across the board. Experts attribute this decline in confidence to a combination of risk aversion generated from the eurozone crisis and to economic factors from within the main emerging markets.
Nearly $6 billion was withdrawn from emerging market funds in the five days before Wednesday, and fixed-income redemptions totalled $3.2 billion – 62% higher than the previous record in October 2008. The JPMorgan EMBI index of bond yields for emerging markets reached a one-year high of more than 6.3%, up from 5.58% at the beginning of September.
The negative view of emerging markets can be at least partly attributed to the turmoil in the financial sector in the developed economies – particularly the crisis in the eurozone. At a time of high risk, investors are keen to divest themselves of their riskier assets.
“What we’re seeing here is spill-over from the crisis in developed markets,” says John Cleary, CIO and managing director at Focus Capital. “What’s going on in Europe is unprecedented, and this is a reaction to that: people are selling what they perceive to be their riskier assets.”
The current situation in the developed economies has led to a reduction in global liquidity that has hurt emerging market funds, which particularly rely on access to liquidity.
“Emerging markets have traditionally been geared plays on global liquidity. As liquidity dries up, emerging markets tend to be the hardest hit,” says Julian Pendock, partner at Senhouse Capital.
The growing sense of risk aversion in the markets has led to a strengthening in the dollar, which has frequently been the currency in which emerging market carry trades are undertaken. This strengthening has had a highly negative effect on these trades.
“Recently, the US dollar has been used as a funding currency for emerging market carry trades, and as the dollar has strengthened due to risk aversion, these trades have been violently unwound,” says Pendock.
However, to attribute a drop in participation in emerging market funds purely to risk in Europe and the US seems to be too simple. Pendock is adamant that at least part of the negative reaction to emerging market funds must be ascribed to problems in the emerging markets themselves. He argues that while people think of a strongly emergent middle class in Brazil being capable of driving growth, they fail to account for limitations in Brazilian spending capacity.
“People talk about the emergence of the Brazilian middle class but they seem to forget that they’re actually spending more on debt servicing than the US middle class at the height of the credit bubble,” says Pendock.
Pendock also argues that overly optimistic evaluations of China’s value to investors are being exposed, leading to falls in stock prices.
“China has problems in its banking system, things may look fine at first glance but a lot of this can be put down to a degree of accounting smoke and mirrors. Western companies that have traded on rich valuations due to a China premium are seeing those premiums evaporate and hence the stocks are de-rating as economic gravity takes its toll,” he says.
However, falling stock prices do not seem to be a uniquely Chinese problem – indices are suffering across Asia. While the Hang Seng has dropped by 4.38% today, the SET in Bangkok is down 5.12% and Indonesia’s IDX has dropped 4%.
One thing that there seems to be agreement on is that even if Europe is not entirely to blame for the declining enthusiasm for emerging markets, there will be no resurgence until Europe sets its house in order. Investors are simply too concerned about events in the developed markets to put capital into what they deem to be risky ventures.
“We aren’t going to see real risk appetite until problems in the eurozone are resolved,” says Pendock.
Analysts at RBS agree with Pendock’s analysis of the situation, arguing that market uncertainty across the globe is likely to keep emerging market funds at a low. “With global macro uncertainty staying high we think investors are unlikely to see the sell-off as an opportunity to buy,” says RBS in a note.