Investing: The great escape
“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
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.
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.
“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.”
“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.
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 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.”