A developing bull market
Nov 26th 2009
From The Economist print edition
Low yields on cash are sending investors far afield
Illustration by S. Kambayashi
THE hunt for the next bubble is well advanced. Gold, which has repeatedly hit record nominal peaks, is a plausible candidate. Like a dotcom stock, it seems to lack any valuation constraints.
Another option is emerging markets. Equities in developing markets have already enjoyed a phenomenal rally this year, with the MSCI emerging-markets index up by 73% as of November 25th. But what about emerging-market debt?
The credit crunch has shown that emerging markets have not only become the main drivers of global growth but have also replaced developed countries as exemplars of fiscal probity. (Dubai is not technically an emerging market.) The bail-out of the banks, an unexpectedly sharp recession and a collapse in tax revenues have pushed some developed countries into deficits of more than 10% of GDP, figures not seen outside world wars.
The contrast is now striking. Matt King, a strategist at Citigroup, cites IMF figures showing that the debt-to-GDP ratio of the leading 20 developed nations is already twice that of the top 20 emerging markets. By 2014 it will be three times as high.
Every bubble needs a plausible narrative, whether it is the transformative power of the internet or the growth potential of emerging markets. It usually needs easy money as well—and near-zero short-term interest rates in America, Europe and Japan fit the bill, as they encourage investors to search for yield. Bubbles also normally need a trigger event to give them impetus. In this case the credit crunch gave investors cause to doubt the growth prospects of rich-world markets and to favour developing countries.
The bullish argument for emerging-market bonds is based not just on the state of government finances but on the outlook for foreign-exchange markets. The American government may talk about the desirability of a strong dollar but it seems to have no intention of doing anything about it. Governments in Japan and the euro zone are hardly applauding the resulting strength of the euro and yen. By contrast, argues Mr King, some emerging countries may find their currencies appreciating, no matter what policy they follow.
What if they give in to Western political pressure and allow a modest currency rise? Then investors will speculate that further appreciation is likely. Alternatively countries may choose to intervene in the foreign-exchange markets to prevent their currencies from rising. But the effect of such a policy will be to increase their foreign-exchange reserves (as they sell their own currencies and buy dollars or euros). That will make the country’s fundamentals look even more attractive and encourage even greater investment.
In addition, importing loose monetary policy from America (as countries try to peg their currencies to the dollar) may create asset bubbles within emerging markets. Those will attract speculative inflows. And if developing countries try to restrict those bubbles by raising interest rates, that will only make their currencies even more attractive as yield-hungry investors pile in.
The trend is already well under way. EPFR Global, an information group, says that emerging-market-bond funds attracted the largest monthly inflow in October since it began collecting the data in 1995.
Spreads (the excess yield over Treasury bonds), as measured by JPMorgan’s index of emerging-market bonds, have fallen from more than five percentage points in October 2008 to less than four percentage points now. To the bulls that leaves room for plenty of further gains: at its narrowest, in June 2007, the spread on this index was 138 basis points (less than one-and-a-half percentage points).
That suggests bubble status is still some way off. To the sector’s enthusiasts, like Jerome Booth of Ashmore, a fund manager, talk of a bubble is absurd. The world is witnessing a secular shift in favour of the developing world, which generates roughly 50% of global GDP but is under-represented in investors’ portfolios, he says.
Buying emerging-market debt is not quite as straightforward as buying equities. The countries to which investors may most desire exposure (China and India, for example) are underweighted in emerging-market-bond indices relative to the likes of Venezuela and Lebanon. There is also the question of whether to buy debt denominated in local currencies, which is less liquid but carries a higher yield. Regardless of the country’s chequered financial history, Brazil’s local-currency debt, yielding 11.8%, must look awfully tempting to income-seeking investors at the moment.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
The credit crunch has shown that emerging markets have not only become the main drivers of global growth but have also replaced developed countries as exemplars of fiscal probity. (Dubai is not technically an emerging market.) The bail-out of the banks, an unexpectedly sharp recession and a collapse in tax revenues have pushed some developed countries into deficits of more than 10% of GDP, figures not seen outside world wars.
The contrast is now striking. Matt King, a strategist at Citigroup, cites IMF figures showing that the debt-to-GDP ratio of the leading 20 developed nations is already twice that of the top 20 emerging markets. By 2014 it will be three times as high.
Every bubble needs a plausible narrative, whether it is the transformative power of the internet or the growth potential of emerging markets. It usually needs easy money as well—and near-zero short-term interest rates in America, Europe and Japan fit the bill, as they encourage investors to search for yield. Bubbles also normally need a trigger event to give them impetus. In this case the credit crunch gave investors cause to doubt the growth prospects of rich-world markets and to favour developing countries.
The bullish argument for emerging-market bonds is based not just on the state of government finances but on the outlook for foreign-exchange markets. The American government may talk about the desirability of a strong dollar but it seems to have no intention of doing anything about it. Governments in Japan and the euro zone are hardly applauding the resulting strength of the euro and yen. By contrast, argues Mr King, some emerging countries may find their currencies appreciating, no matter what policy they follow.
What if they give in to Western political pressure and allow a modest currency rise? Then investors will speculate that further appreciation is likely. Alternatively countries may choose to intervene in the foreign-exchange markets to prevent their currencies from rising. But the effect of such a policy will be to increase their foreign-exchange reserves (as they sell their own currencies and buy dollars or euros). That will make the country’s fundamentals look even more attractive and encourage even greater investment.
In addition, importing loose monetary policy from America (as countries try to peg their currencies to the dollar) may create asset bubbles within emerging markets. Those will attract speculative inflows. And if developing countries try to restrict those bubbles by raising interest rates, that will only make their currencies even more attractive as yield-hungry investors pile in.
The trend is already well under way. EPFR Global, an information group, says that emerging-market-bond funds attracted the largest monthly inflow in October since it began collecting the data in 1995.
Spreads (the excess yield over Treasury bonds), as measured by JPMorgan’s index of emerging-market bonds, have fallen from more than five percentage points in October 2008 to less than four percentage points now. To the bulls that leaves room for plenty of further gains: at its narrowest, in June 2007, the spread on this index was 138 basis points (less than one-and-a-half percentage points).
That suggests bubble status is still some way off. To the sector’s enthusiasts, like Jerome Booth of Ashmore, a fund manager, talk of a bubble is absurd. The world is witnessing a secular shift in favour of the developing world, which generates roughly 50% of global GDP but is under-represented in investors’ portfolios, he says.
Buying emerging-market debt is not quite as straightforward as buying equities. The countries to which investors may most desire exposure (China and India, for example) are underweighted in emerging-market-bond indices relative to the likes of Venezuela and Lebanon. There is also the question of whether to buy debt denominated in local currencies, which is less liquid but carries a higher yield. Regardless of the country’s chequered financial history, Brazil’s local-currency debt, yielding 11.8%, must look awfully tempting to income-seeking investors at the moment.
Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.
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