Investing: The great escape


Switch into emerging markets is less about potential growth and more to do with stagnation at home
 
EM markets
 
 
When the world’s biggest fund manager reverses its view on half of the global economy it is time to take notice. That is what BlackRock, manager of $4.6tn for investors and savers , has done this year. Once negative on emerging markets, it has turned into a cheerleader for them.
 
Sergio Trigo Paz, BlackRock’s head of emerging market fixed income portfolio management, now talks of a “great migration” — a mass movement of big institutional investors away from the stagnant growth and negative interest rates of the developed world, to the resurgent economies and enticing yields of emerging markets.
 
“This is not just the tactical guys,” he says. “This is pension funds, sovereign wealth funds. The big, big guys are starting to move.”
 
Flows to emerging market bond mutual funds — a small but significant part of the investment universe, and one of the few sources of real-time investment data — tell a dramatic tale. After a bout of panic over China at the start of 2016, investor sentiment warmed to the sector in the following months , and surged into emerging market bonds in July.

But it is far from clear that this signals a fundamental change of fortune for the real economies of emerging markets. They account for 52 per cent of global economic output calculated in terms of purchasing power parity and 38 per cent in nominal terms, so the answer to the question is of huge significance for the global economy. If they really are taking a turn for the better, it could offer a new locomotive of growth for a sickly world.
 
The latest growth forecasts from the International Monetary Fund offer some optimism. It expects the pace of gross domestic product growth in emerging markets to increase every year for the next five years while developed markets stagnate.
 
But in truth emerging markets are growing from a shrunken base and a big part of the upturn is not due to things getting better but to things no longer getting worse. Big economies such as Russia and Brazil, for example, in deep recession for the past two years, are finally heading back to growth.

“Last year, it was all doom and gloom,” says Peter Kinsella, head of EM research at Commerzbank. “But EM as a whole is about to post its strongest GDP growth in four years.”

Push and pull

There are parts of the emerging world showing genuine signs of economic strength, including Poland and the Czech Republic in eastern Europe, Mexico in Latin America, and large parts of Asia — Vietnam, the Philippines, India, Sri Lanka, Bangladesh, even Pakistan. This can be traced in part to governments having put public finances in better order and some, notably Mexico and India, embarking on ambitious reform programmes.
 
EM markets
EM assets began the year gripped by panic over China’s slowing economy. But those fears faded, as did any immediate prospect of the US Federal Reserve adding to its December rate rise. In February, BlackRock changed its call on EM bonds, saying they would deliver double-digit returns in 2016


However, even though these pockets of optimism are real, the massive flows into emerging market debt and equities should not be taken as a sign of the start of another breakout period for these economies, say analysts. The flows are as much an escape from low yields in developed markets as they are a sign of faith in their emerging counterparts.
 
Big questions still hang over the asset class, in the shape of the US Federal Reserve’s monetary policy, China’s inexorably rising mountain of debt, and the still fruitless search of emerging economies for a growth model to replace the commodity and credit-driven booms of the first dozen years of this century.

“Fund flows to EMs have gone through the roof,” says Mr Kinsella. “But this is best described as [the result of] push factors rather than pull factors.” Those push factors have become immensely powerful.

“The old-school thinking was that emerging markets had a lot of growth but lots of risk and that safety was in places like the UK,” says Anthony Cragg, a senior portfolio manager at Wells Fargo Asset Management. “The events of the past few weeks [following the UK’s vote to leave the EU] have made people rethink that whole notion.”
 
The shock of Brexit
 
It is not only the UK’s leap into the political unknown driving such a re-evaluation. Elections in the US, France and Germany over the next 12 months and repeated terrorist attacks have made the developed world look a lot less safe.
 
 
EM markets
In the 2000s, EM economies not only outpaced their developed counterparts, they did so by a widening margin. After the global financial crisis, while EMs still grew more quickly, the margin narrowed. Now it looks set to expand again


Developed markets have also become much less dependable as a source of growth and investment returns, especially for US public sector pension fund managers who must somehow try to secure returns of 7 to 8 per cent a year. The ultra-loose monetary policies of recent years have mostly failed to deliver a return to economic growth in the developed world. The same policies now mean that more than 30 per cent of global government bonds are trading at negative nominal yields, and a once-reliable source of returns for would-be retirees, and many others, has run dry.

Until this year, nobody would have taken seriously the idea that emerging markets could make up the shortfall in economic growth. EM stocks spent much of 2015 in free fall, losing more than a third of their value from a peak in April to a trough in January 2016. Economic growth in these countries has been a serial disappointment. As the IMF figures show, aggregate GDP growth in emerging markets has fallen every year since 2010, while the developed world has spent the past three years in post-crisis recovery.

That this is now changing marks a big shift in the dynamics of global growth. However, Ruchir Sharma, head of EM equities and chief global strategist at Morgan Stanley Investment Management, offers a note of caution. He says investors in emerging markets are less concerned about whether these economies are growing more quickly than those in the developed world. Rather what excites them is whether the differential between GDP growth in the two is actually increasing.
 
“EM has been growing faster than DM for the past five years and yet EM has underperformed because the differential has been collapsing,” he says. “This year the differential has stopped collapsing. It has stabilised.
 
“This is the single best predictor of performance for equity markets.”

But he dismisses any suggestion that this heralds a return to the glory days of the 2000s, when emerging markets consistently outperformed those in the developed world by a wide margin and foreign capital flooded in.


In 2007 — the peak of the boom for emerging markets — there were 60 economies in the world that were growing annually at a pace of more than 7 per cent, Mr Sharma notes. “Today, that number is down to eight or nine countries,” he says. “The baseline for success is changing everywhere.”

During those boom years, China was the powerful driver of growth, sucking in exports from other emerging markets, especially commodity producers, to sustain a frantic pace of investment and urbanisation. This model has run its course and today, says Mr Sharma, China’s growth trajectory is similar to that of a ping-pong ball bouncing downstairs. “Every time growth slows down too much you get a government stimulus and a pop up, and then it falls back down,” he says. “The rebound gets smaller every time. But at least the ball hasn’t broken so far.”
 
China’s ‘kiss of debt’
 
The problem is that the effort required to make China’s economy “pop” each time is getting bigger and bigger. Before the global financial crisis, says Mr Sharma, China needed one dollar of credit to deliver one dollar of growth. Now the ratio is six to one.

“They are finding it impossible to grow without increasing quantities of debt,” he says. “It is the kiss of debt.”

In his book, The Rise and Fall of Nations, Mr Sharma highlights the danger behind China’s rapid debt build-up. By isolating the most severe credit binges among 150 countries going back to 1960 he found that the crucial numbers were a five-year long expansion of debt and an increase in private credit equal to more than 40 percentage points of GDP. This, he found, has happened on 30 occasions.

EM markets
This year’s rally in EM bonds – shown here as falling yields that correspond to rising prices – may reflect optimism over emerging economies; or it may be little more than a product of a global rally in fixed income assets. If the latter, its driver is US Federal Reserve monetary policy
 
 
“In all cases, in the subsequent five years, there was a massive economic slowdown,” Mr Sharma says. It is unlikely, he adds, that China — where growth is already stalling — will avoid such a fate.
 
In the five years to the end of March 2016, according to the Institute of International Finance, an industry body, private sector debt in China — owed by households and non-financial sector companies — increased by 62.1 percentage points of GDP. If Mr Sharma is right, the future does not look good for China, emerging economies, or the world.
 
Despite such warnings investors are being drawn to the yields offered by Chinese debt. Anthony Chan, Asian sovereign strategist at AllianceBernstein in Hong Kong, describes the Chinese government bond market as “very attractive”. The 10-year bond, for example, currently yields 2.74 per cent a year, a far more appealing proposition than the negative rates on offer elsewhere.
 
Even if they are wary of China, other asset managers say there are growth stories to be found in other parts of Asia, in eastern Europe and Latin America. BlackRock’s Mr Trigo Paz, who changed his view on EM bonds in February, describes what is happening now as a “capitulation” — a realisation by big institutions that they can no longer afford to ignore the returns on offer in emerging markets, which have been as high as 13 per cent in the year to date.
 
So while many investors have been put off by high-profile risks in countries such as Brazil and Russia, others are now warming to growth stories in places such as Vietnam, currently punching well above its weight in attracting foreign direct investment, the Czech Republic, where GDP growth is humming at more than 4 per cent, and India.
 
For investors keen to earn the returns on offer, says Mr Trigo Paz, “the fundamental rationale box has been ticked”.

Waiting on the Fed
 
Yet rather than pro-growth reforms in emerging economies, many believe the force driving the investment flows is the US Federal Reserve and a belief that its interest rate stance of “lower for longer” has morphed into one of “lower forever”.

 
 
The Fed led the move to ultra-loose monetary policies after the global financial crisis, and was later joined by its central bank counterparts in Europe and Japan . One of its aims was to drive down the returns available on “safe” assets in the hope of encouraging investors to take risks and drive growth in the real economy. In part the policies have worked. The yield on 10-year US Treasury bonds, for example, has fallen from 2.3 per cent to less than 1.5 per cent over the past year.
 
David Hauner, head of EM strategy at Bank of America Merrill Lynch, says this has driven flows into EM bonds and the corresponding fall in yields.

“The EM bond rally is really a global fixed income rally,” he says. Fundamentals in emerging economies may have improved, he adds, but not by much: the real driver is the dearth of yield in developed market assets.

The impact of such flows on EM sovereign bond prices, which have risen 15 per cent this year, has been amplified by the fact that the asset class is small. An estimated $12tn of developed market government bonds now offer yields of less than zero, while their emerging market equivalents add up to about $800bn, so their ability to offer an alternative is limited.

For now, the pressure on prices has all come from buyers and for those who got in early the returns have justified the risks. The trick will be to know when to head for what could quickly become a very crowded exit.

“It will be painful on the way out, for sure, but nobody knows when the trigger will come,” says Dirk Willer, head of EM strategy at Citi. “We’ve had a lot of scares about China and nothing has happened. But when it happens, it will be ugly.”

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