Fast forward to 2029. A slowdown in the global business
cycle gathers pace as Asias consumption binge eases. Fund
managers on the defensive migrate to liquid assets: Latin, Gulf
and Asian sovereign bonds. Chinese Treasury bills hit a record
low as investors flee to safe havens.
Western economies without current account support see their
currencies plummet as exports to Asia and Latin America
nose-dive. Meanwhile, there are demands in US and Europe for
pension funds to reduce their allocations to Asian and Latin
American assets to bring much-needed capital home.
Some even call for the creation of an international currency
to challenge the dominance of the Chinese yuan. But the Asian
head of the IMF quashes such talk.
This reversal of fortunes in the global financial economy is
on its way or so a handful of emerging market bulls
would have it.
This present crisis has brought in an enormous shift
in underlying economic power from the US to the Brics [Brazil,
Russia, India and China], and in particular, China, and this
will be enormously beneficial for financial markets, says
Jim ONeill, head of global economic research at Goldman
Sachs in an interview with Emerging Markets.
The U-turn in risk appetite since March has been
sensational. Investors had dropped emerging market assets
following the collapse of Lehman Brothers. A massive fall in
equity, credit and foreign exchange markets wreaked financial
havoc upon eastern and central Europe, Asia and Latin America
as well as the Middle East.
By the end of 2008, emerging market equities had dropped
54.5% in dollar terms. High-yield Latin American corporate
bonds in JP Morgans bond indices were down between 30%
and 35% in 2008 compared with losses in emerging Europe at
The few investors who could fight off the flood of
redemption requests to grab emerging market assets last autumn
are now sitting on tidy profits.
But todays enthusiasm for emerging markets is no
longer just a handy marketing pitch. Emerging stock markets
have jumped by over 60% since the start of the year. Hard
currency sovereign bonds have been hovering around 320bp over
the past month less than just before Lehmans
In August, Russian five-year credit default swaps (CDS)
traded through California while Indonesian credit protection is
currently tighter than Michigan. Investors are betting some
developing countries are less likely to default than the
developed world. Meanwhile, jumbo equity and debt offerings
from emerging market equities have been massively
over-subscribed and carry trades are in full swing.
The energy of this rally amid an expected period of
sub-par developed world growth and continued deleveraging
has taken many by surprise given the weak risk appetite
during typical economic downturns.
A large part of this has been fuelled by relief: fears of a
global depression, or poor Chinese growth or a double-dip US
recession have not materialized. This is a risk re-rating
rally driven by a very visible sense of relief that emerging
markets are not in a crisis, says Jonathan Anderson,
chief emerging markets economist at UBS.
Instead, the fear of an economic crisis has been replaced by
concern over missing out on the rally. This relief has also
been powered by a global injection stimulus. We have a
massive anti-depression policy with gigantic fiscal and
monetary support. Its the biggest liquidity stimulus in
our generation, and it wont be wound down anytime
soon, says ONeill.
In addition, economic data continues to provide evidence
that the global economy has emerged from its trough. This will
lead to a modest recovery in the developed world and release
pent-up domestic demand in emerging markets. We have not
seen a vicious send-round of crises. Even eastern Europe has
been surprisingly quiet and signs of recovery have
emerged, says Anderson.
Since the beginning of the year, investors have committed
over $55 billion to emerging market equity funds to reverse
nearly 80% of 2008 outflows, according to Commerzbank. Flows
into global emerging markets bond funds have continued to
surge. They hit a three-year high of $727 million during week
ending September 23, according to data provider EPFR
This is largely because investor allocations to emerging
market credits have lagged equity and commodity funds as
investors launched an unbridled quest for yield. Some analysts
argue emerging market sovereign debt could yet tighten
There was far more competition for emerging markets at
the beginning of the year from the US high-grade market, which
offered much higher yields than emerging markets debt, in
addition to having a lot of sponsorship from the US
government, says Joyce Chang, head of emerging markets
research at JP Morgan.
Yields for the US high-grade market have gone down to
close to 5% from a peak of 8.67% at the beginning of the year,
whereas yields for JP Morgans emerging markets bond index
global, the EMBIG, are still around 7% for emerging markets.
This should attract further investor inflows, says
According to Barclays Capital, emerging market investors are
set to receive around $10 billion of interest and amortization
payments from sovereign and quasi-sovereign borrowers for the
remainder of the year. This cash should give investors plenty
of ammunition to snap up an expected flurry of deals for the
remainder of the year without widening spreads.
The sell-off in emerging market corporate debt last year was
exacerbated by forced selling from levered investors. Russian
and CIS bonds, which have lower subscription levels from real
money investors, plummeted as hedge funds blew up and so
underperformed their Latin American counterparts. In addition,
a chunk of the bonds issued from Russian and CIS borrowers came
from banks that have been hit by impaired balance sheets and
But since the spring, there has been a massive rally in the
corporate emerging markets bond index (CEMBI), which tightened
by almost 50bp in September and now stands around 410bp, a
massive year-to-date tightening of 575bp.
Investors have already locked in profits from Russian,
Ukrainian and Kazakh corporate credits. Chang says: The
market rally for the low-quality segment of corporate issuers
has probably got ahead of itself as the emerging market
high-yield corporate default rate has yet to peak.
There may be less exciting returns for the corporate world
in the near-term. But this misses a more profound issue:
emerging market investors are relieved that a post-Lehman world
order has not resulted in a sustained underperformance of the
asset class or reshaped its relative risk premiums. Bearish
analysts feared the crisis would usher in an era where foreign
investors would remain in their more liquid and typically
In fact, the opposite has occurred. Between mid-September
last year and end-March, emerging market high-grade credit
widened dramatically in the storm of forced selling. Barclays
Capital says that pricing for investment-grade emerging market
borrowers (BBB or above) compared with similarly rated US
corporates has reverted back to its long-term average.
A recent Moodys research note said: At 7.65%,
the global emerging market borrowing rate the sum of
emerging market sovereign and corporate rates with US Treasury
rates is less than half the cycle peak set last
Dmitry Sentchoukov, an emerging market credit strategist at
Dresdner Kleinwort in London, says: The link between the
spreads of emerging market corporates and sovereigns and
G7 corporates has proved to be sufficiently robust during
the current crisis.
But what about equities? As global growth prospects
brightened since the spring, stocks are now pricing in sky-high
The forward price-earnings (p/e) ratio for emerging market
stocks is around 13x above their five-year historical
average of 11.5x and not far off before the peak of late 2007,
according to Hung Tran, senior director of the capital markets
department at the Institute of International Finance.
Emerging market equities may not necessarily be
overvalued, but whenever valuations reach above their
historical norms, people should start at least worrying,
Strong liquidity, investor inflows and supportive economic
news may see the forward p/e levels for emerging market stocks
breach developed market stocks valuations, which is currently
15x. This would mean that investors would be paying more for
each dollar return in expected earnings from emerging market
companies than for developed markets despite the
typically higher cost of capital in the former.
If you look at the forward multiples right now,
China and India trade at a higher rate than the US, says
Goldmans ONeill. It means that these stocks
are not quite as attractive as last year when people
were talking about how the emerging world would disappear into
Stock market valuations are pricing in pre-crisis growth
expectations at a time when the global economy is at a
crossroads. The thesis that emerging market countries can
support their own growth without G7 demand is without any
evidence and so points to significant uncertainty for equity
valuations, says David Chon, who manages a $150 million
multi-asset hedge fund.
CHANGING RISK PERCEPTIONS
He says investors have effectively given up trying to
discriminate between the policy-led stimulus and the
real-economy drivers for the rally in emerging market assets.
Instead, he says the equity market may be a bubble but is still
a good investment as long as prudent allocation strategies are
Historically, emerging markets have lower multiples than
developed bourses due to the higher perceptions of risk, lower
liquidity and higher cost of capital. Tran says because the US
Federal Reserve is expected to maintain loose monetary policies
for a prolonged period, the cost of capital to invest in
emerging markets will remain low.
In any case, this factor has been on a downward trend in
recent years as financial globalization has gathered pace.
Tran, who is a former deputy director of the monetary and
capital markets department at the IMF, says the crisis has
underscored the macroeconomic and business risks in the
G7 that have not been priced in. As a result, the risk
premium that investors demand to invest in higher-growth
emerging markets should decline in relative terms. Risk
perceptions are changing and have to change, he
Some analysts say investors should brace themselves for a
sustained bull market for emerging market assets. The
structural weakness of the West huge debt burdens,
ageing populations and weak banking systems has
increased the relative strength of emerging markets in terms of
global economic power. JP Morgan predicts developed economies
will shrink 3.3% this year but grow 2.8% in 2010 compared with
growth of 0.5% and 5.8% in emerging markets.
This year will be remembered as the year that emerging
markets became the driver of global growth, registering
positive growth as the developed world experienced its worst
recession in decades. Emerging market countries have passed a
major stress test, says Chang.
In other words, decoupling was the wrong label for the right
Global business and credit cycles will become increasingly
correlated as globalization continues. But the growth
outperformance of emerging markets is here to stay, so the
argument goes. This will serve to ensure the
sustainability of high relative valuations on emerging market
assets over the next few years, says UBSs
US pension funds have just a 0.7% allocation to emerging
market debt. But in an environment of strong investor inflows,
stable valuations and changing risk perceptions, a sea change
in traditional investment behaviour could just be around the
corner, says ONeil. I am hearing from the long-only
US pension fund world that advisers are recommending raising
their neutral benchmark on emerging markets to
The world is getting used to bubbles. The crisis in Europe
and the US has turned from a bubble in housing and corporate
debt to one in government debt. In China, fiscal and monetary
stimuli to deal with the bursting of the bubble in exports may
have created a bubble in property markets in Hong Kong, Macau
But what is clear is that emerging market sovereigns and
corporates are underlevered and are less susceptible to a
cost-of-capital shock. As a result, the fallout from asset
bubbles in emerging markets is less likely to wreak havoc on
their economies compared to the tumult witnessed in the