The audacity of hype?

03/10/2009 | Sid Verma

The global financial crisis has prompted a rethink of where investor value lies in a post-Lehman world order. Volatility won’t abate soon, but an oft-touted long-term shift to emerging market assets now seems inevitable

Fast forward to 2029. A slowdown in the global business cycle gathers pace as Asia’s 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 O’Neill, 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 Morgan’s bond indices were down between 30% and 35% in 2008 compared with losses in emerging Europe at 43%.

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 today’s 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 Lehman’s collapse.

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. It’s the biggest liquidity stimulus in our generation, and it won’t be wound down anytime soon,” says O’Neill.

MODEST RECOVERY

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 Global.

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 further.

“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 Morgan’s emerging markets bond index global, the EMBIG, are still around 7% for emerging markets. This should attract further investor inflows,” says Chang.

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 deleveraging.

VINDICATION

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 efficient markets.

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 Moody’s 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 October.”

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 G–7 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 earnings expectations.

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,” he says.

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 Goldman’s O’Neill. “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 the oblivion.”

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 G–7 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 followed.

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 G–7 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 says.

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 theme.

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 UBS’s Anderson.

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 O’Neil. “I am hearing from the long-only US pension fund world that advisers are recommending raising their neutral benchmark on emerging markets to overweight.”

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 and Taiwan.

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 West.

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