Safe havens. Decoupling. Outperformance. These buzzwords marketing the structural strength of emerging market assets have been falling on deaf ears lately. Developing market bonds, currencies and stocks have been savaged by global deleveraging, risk aversion and a wholesale flight to safety in the grip of the Western financial meltdown.
In addition, large co-ordinated liquidity injections in developed countries have failed to inject risk appetite or rectify the perilous dislocation in the financial system. Financiers are unwinding trades and global bank balance sheets remain illiquid as fear stalks the international system and shuns risk markets.
With emerging market equities and bonds underperforming US stock and high yield bond markets, the dollar strengthening and emerging currencies plummeting you could be forgiven for thinking the bull run for emerging markets now seems like a distant memory.
"Foreign exchange volatility had been very low until the summer, and the dollar depreciated steadily since the end of 2005," says Helene Williamson, head of emerging markets debt for F&C Investments in London. "Given the deleveraging, there is now strong momentum for the dollar to strengthen and emerging currencies are likely to become more volatile."
Risky assets tend to underperform in a cyclical downturn as investors migrate to safer assets. But the monumental drive to repatriate capital has taken many investors by surprise. According to the US Department of the Treasury, US investors sold off $92bn more international stocks and bonds than they bought between July and September the largest ever flight from foreign markets. In addition, the MSCI emerging market stock index shed 27.6% in the third quarter of 2008, the worst fall in its 20 year history.
Despite the horrendous losses in Western assets, many investors have still rerouted cash away from emerging markets to US equity and money market funds. Meanwhile specialist fixed income managers on the defensive have become overweight in liquid sovereign bonds in strong economies such as Brazil, since the onset of the credit crunch in August 2007.
"We have been underweight emerging corporate debt for the whole year, selling our positions in strength given large corporate issuance," says Williamson.
As global growth hits exports and consumption in developing economies, investors are positioning themselves for falling bond prices, weak equity markets and sustained exchange rate volatility. With leverage being hunted down and destroyed wherever it is found, the new mantra is: build up cash, differentiate, and ride through the credit crash with long term capital.
In fact, the violent volatility in credit spreads is vexing investors who are puzzling over the relative valuation of emerging market bonds against perceived peers. "You have to look at whats happening to assets globally when you are confronted with opportunities to be paid for risky names," says George Estes, analyst for the $4bn emerging country debt fund at US-based Grantham, Mayo, Van Otterloo.
But as fear in the financial system causes spreads to jump above its credit quality fundamentals, relative value analysis is effectively meaningless. "Valuations have become unhinged from fundamentals," says Blaise Antin, head of research for the $1.9bn TCW Emerging Market Fixed Income Fund.
The rush to build up cash has accelerated. But "as investors try to exit a position, you sell off another asset uncorrelated. So fundamentals are not driving anything," explains Claudia Calich, a senior emerging markets portfolio manager at Invesco in New York.
But thin liquidity is also forcing portfolio allocators to retain their positions "since in many cases the bid offer is nowhere," says Kieran Curtis, manager of around $750m in two emerging market debt SICAV funds for Morley, the fund management arm of UK-based pensions and insurance firm Aviva.
In addition, lower commodity prices and slowing growth will drag corporate earnings down in 2009. As a result, investors are only willing to bet on non-cyclical, high grade and cash rich corporates. But in any case, the corporate bid is "likely to underperform EM sovereigns over the next few quarters given their risk and relative illiquidity," says RBC Capital markets in a recent report. "In this environment, cash is king, and we look for corporates that have large stable cashflows, strong cash positions and low near term debt maturities to vastly outperform while lower tier corporates may be adversely affected by fiercer competition for funding."
Glimmers of hope
Nevertheless, as central banks in emerging markets inject liquidity and cut interest rates, investors can snap up local currency long-duration assets now before monetary easing takes effect. While deleveraging causes asset prices to overshoot long term fair value, portfolio managers with backing to stay long could potentially make huge returns, say analysts.
But near term price direction and investor strategy is just one part of the pro-EM argument. Emerging market enthusiasts have seized upon the Western origins of the global credit crunch to argue for the structural strength of developing countries. They cite strong relative growth prospects, long term currency appreciation and asset base expansion as reasons why emerging assets will outperform.
In addition, they highlight increasingly credible fiscal and monetary policies in many developing nations along with strong cash reserves to cushion against wholesale capital repatriation.
"Everything in economic theory tells you that emerging market asset prices will outperform in the future, we just need stability in core markets developed credit, equity and foreign exchange first," says Luis Costa, a London-based emerging markets strategist at Commerzbank. For these reasons, portfolio managers have ample ammunition when they advise against redemption requests from fearful investors.
However, the extent to which nations with current account surpluses and strong public finances have been savaged has taken many by surprise. Between 2000 and middle 2008, Russia built up a warchest amounting to $560bn of foreign currency reserves thanks to surging energy prices. But investors have fled Russian risk on the back of lower commodity prices and banking sector leverage, causing the rouble to plummet and the central bank to haemorrhage its cash reserves.
Falling oil prices and strong inflation has also triggered a surge of capital repatriation out of the Gulf. This, coupled with money supply controls, has reduced domestic liquidity causing regional equity markets to tumble and spreads to widen on Gulf corporate bonds. Just as investors were willing to forgo weak fundamentals in deficit nations in emerging Europe during the bull run, in the current bear market, it appears investors can take prisoners in neither deficit nor surplus nations.
The case of the disappearing investor base
EM debt markets are also challenged by a declining investor base with crossover investors falling by the wayside, while distressed debt in developed markets may look more promising. In addition, the astonishing supply of developed government debt that is poised to flood the market over the next couple of years will surely crowd out money that could be put to work in risk markets.
The extent to which this violent global credit cycle will disrupt the secular trend of emerging capital market growth is hotly debated. Calich at Invesco argues that we are in a new era where leverage is stigmatised and the financial landscape is shrinking. For these reasons, portfolio investment in emerging markets will suffer for years to come. "The investor pool will shrink globally not just for emerging markets, and there will also be fewer dealers and less liquidity," she says.
However, the shallow nature of capital markets and lower leverage levels relative to GDP in developing countries will serve to limit systemic losses. In addition, the presence of long-only strategic non-levered pension funds and other institutional investors should help to stabilise sovereign fixed income prices and keep solvent corporates liquid once market conditions normalise.
But what will ultimately drive strategic asset allocation in the long term is down to the rebalancing of global powers, argues Alberto Bernal, head of emerging markets macro economic strategy at Bulltick Capital Partners in Miami. "The relevant question is what comes after the deleveraging cycle, the question is a function of the shifting of powers in the world economy."
Poorly regulated financial systems misallocated high credit risks in developed markets. This fuelled a period of above-potential growth facilitated by an over-leveraged consumption binge based on the belief that real wealth and future income streams was higher than in reality. This has exposed the structural weakness of developed economies and has "hastened emerging markets march to global power", says Jerome Booth, head of research at Ashmore Investment Management.
The US investment banking meltdown underscores the need to rebalance portfolios away from industrialised assets due to systemic economic weakness, the argument goes. "We should now see a flight to quality to emerging markets. I just dont see value in the US and Europe," says veteran emerging market investor Mark Mobius at Templeton Investment Management in Hong Kong. The crisis in the US leveraged loan market "means the whole concept of risk has to be re-evaluated," he adds.
Mobius argues global financial power is at last shifting and structural dollar weakness will soon reign. The IMF estimates developing economies will grow 4.1% in 2009 compared with recession in the US and Europe. In addition, there are question marks around the willingness of foreign central banks to finance the US deficit, suggesting the market should price risk in US Treasuries. So, despite the higher costs of hedging exchange rate risk, local currency assets are therefore a "hedge against structural dollar weakness," says Mobius.
Ashmores Booth who advises monetary authorities about reserve management argues emerging central banks are poised to invest in local and external sovereign bonds issued by emerging nations and, over the long haul, highly rated corporate bonds. This would rapidly expand the local capital market universe and provide a stable investor base.
But this is not the right environment for strategic asset allocation as fear takes hold and credit spreads overshoot long term fundamental values. More crucially, there are question marks over to what extent allocation is made on the basis of strategic economic theory rather than betting on the appreciation of given credits "untied to grandiose notions on the changing world," says Jorge Suárez-Vélez, investor for high-net worth individuals in Latin America at Global Plus Investments in New York.
In the near term, once investors are comforted that risks are priced into EM bonds, a bear market rally could transform into a sustained rebound. But it is Chinas growth levels that will ultimately determine to what extent global growth will rebound and if the US can spend its way out of recession courtesy of Asian cash a clear indication of the rebalancing of global financial power.