There is a long list of reasons to be bearish. In recent years, the structure of emerging-market borrowing has shifted. From African sovereigns to Chinese property companies, the relative importance of capital markets, compared with bank-finance, has jumped.
In December, the Bank for International Settlements sounded the alarm over emerging market debt build-up and the impact of the rising dollar. It calculated net non-bank private debt issuance at $660 billion between the fourth quarter of 2008 and the third quarter of 2014.
But the China commodities super cycle that has powered EM capital inflows over the past decade is over. ECB balance-sheet expansion is unlikely to offset any Fed-hike-driven liquidity squeezes in 2015.
EM local-currency yields have become more sensitive to US yields in recent years. The cost of FX hedging remains high. And historically, EM FX, as a basket, has failed to outperform in a strengthening dollar environment.
Capital misallocation
The prolonged era of US quantative easing has no doubt triggered capital misallocation in high-yield markets. Maturity, liquidity and currency mismatches will be revealed as liquidity tightens. The recent growth of retail participation in EM-focused mutual funds poses risks. The ability of local pension funds and long-only real money funds to act as stabilizing forces during capital outflows could once again be tested in 2015.
However, market technicals also suggest reasons for optimism. Over the past two years, investors were caught off-guard by the limited capacity of dealers to provide hard- and local-currency liquidity as prices adjusted to the end of QE. So 2015 sees modest cyclical positioning in current-account deficit economies, relatively tight value-at-risk calculations and, at least compared to May 2013, big cash piles on the sidelines.
What’s more, amortisations and coupon payments at a combined $160 billion – or 35% of a projected $350 billion EM hard-currency corporate bond supply – will boost investor firepower in 2015, according to Bank of America Merrill Lynch. EM fixed-income also remains a structurally under-invested asset class, which should continue to justify inflows.
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| Emerging markets: special focus |
Spreads across the board, from hard-currency sovereign to local-currency corporates, are wide relative to US Treasuries and US high-yield, respectively. South Africa, South Korea, Hungary, Poland, Mexico and Turkey are among the worst positioned for a sell-off, given their high stock of foreign portfolio investment as a percentage of GDP. Nevertheless, these risks are well flagged, while many of the large Chinese and Indian issuers have stable dollar revenues.
These factors suggest, from a flow and pricing perspective, market adjustments to a US rate hike and strengthening greenback should be less severe than witnessed over the past two years.
The macro fallout from US rate hikes should also not be over-stated. BAML analysts predict EM growth at 4.5% in 2015 – led by Brazil and India – and lower energy prices, while exports to the US are projected to rise from 4.2% in 2014. Floating exchange rates, with the notable exception of much of sub-Saharan Africa, will also continue to act as shock absorbers in the event of large capital outflows.
For investment banks, as witnessed in 2014, a sell-off in local credit and FX markets could also be accompanied with stable deal-flow in DCM, ECM and M&A. The volatility offers bulge-bracket firms opportunities in hedging and risk-advisory, as well as structured and private-placement trades.
In any case, the mid-October US Treasury liquidity crisis – when yields notched an astonishing seven standard deviations away from the intraday norm – while EM fixed-income markets remained relatively stable, upends the conventional view that liquidity squeezes are more common in emerging than developed markets.