A WAVE OF LIQUIDITY WILL CONTINUE TO WASH OVER EMERGING MARKETS / THE FINANCIAL TIMES MARKETS INSIGHT

A wave of liquidity will continue to wash over emerging markets

Big tests await but many Covid-19-stricken nations have been able to raise money cheaply

Jonathan Wheatley


Brazil was among the growing number of EMs able to tap global capital markets this month © Bloomberg


Emerging markets have rallied sharply from the panic-fuelled sell-off at the end of March, but not by as much as developed markets. This may reflect the evidence that, with the exception of a few countries, the number of coronavirus infections is still rising in the developing world even as it falls in advanced economies, and that developing countries are set to suffer the greatest economic damage.

Of greater significance to investors, however, is the tidal wave of monetary stimulus from the US Federal Reserve and other central banks, which arrived in emerging markets after sweeping through other classes of assets.

Not everyone wants to ride this wave. Arthur Budaghyan, chief emerging market strategist at BCA Research, describes what is happening as a “FOMO-driven mania”. With markets pumped up on trillions of dollars of liquidity, fear of missing out is driving US retail investors to bet their stimulus cheques on companies apparently heading into bankruptcy.

Institutional investors, he said, have had little choice but to join in, and their thirst for yield has driven portfolio flows back into emerging markets after they experienced record-breaking outflows in March.

“This rally is close to the end and it would be very dangerous to chase it,” Mr Budaghyan told clients on a recent call.

This mania could persist, he said, “but manias are not driven by fundamentals and rational forecasters cannot forecast them.”Others see good reasons to join the rally right away.

Uday Patnaik, head of emerging market debt at Legal & General Investment Management, said the late-March sell-off was a “tremendous buying opportunity”, and one that was still open. “In the second half of this year, we still think EM debt can generate high returns and we remain constructive,” he said.

Backing that claim is the current wide gap between yields on emerging and developed market sovereign bonds, which he expects to narrow this year.

But which assets to buy? As private individuals, many investors have been appalled by the nonchalance with which Jair Bolsonaro, Brazil’s president, has addressed — or not addressed — the pandemic. As investors, however, they seem undeterred by the costs of that negligence.

Brazil was among the growing number of EMs able to tap global capital markets this month, selling $3.5bn of five and 10-year bonds at lower interest rates than expected.

Investors were reassured by the size of Brazil’s foreign currency reserves and its low level of foreign currency debt. Similarly, Egypt and Pakistan have been able to get eurobonds away thanks to the backstop of the IMF. The big test of risk appetite, according to Mohammed Elmi, portfolio manager in EM fixed income at Federated Hermes, “will come when we see real EM corporate issuance, frontier sub-Saharan issuance, or troubled core EM sovereigns such as Turkey and South Africa”.
Meanwhile, one bottom-up approach is to look for “good companies in bad countries”, said Michael Israel, a founding partner at IVO Capital Partners, a French boutique specialising in corporate debt that manages about $1bn in assets.One basis of this strategy is that no matter how strong a company’s balance sheet, its credit rating will be limited by the sovereign rating of its country.

This lowers the price of its bonds.Another is that a well-funded company in an emerging market, whose cash flows are relatively undamaged by the crisis, is a better prospect than one that has to load up on debt to keep trading.

In a market functioning normally, he argues, good and bad companies will be differentiated by the quality of their balance sheet and management. But in markets protected by the Fed’s quantitative easing, especially when delivered en masse and at speed, there is no opportunity for such distinctions to emerge.

“There is a big difference between liquidity provided to avoid a short-term default risk, and liquidity provided to address a solvency risk,” he said. “The more your solution to a liquidity problem is to add more debt, the more you increase in parallel the solvency risk. The only way to avoid this is through an equity injection.”

It is hard to resist making an analogy with sovereigns and to conclude that what emerging markets stricken by the pandemic need is not more debt or even debt relief, but outright grants.

But the tide of Fed liquidity may yet make such arguments moot. Data from CrossBorder Capital, a consultancy, show that the relationship between global liquidity and financial asset prices has been close for three decades. After the trillions injected since March, asset prices still have ground to make up.

As Oxford Economics noted on Friday, “The experience of the last three months suggests that in sufficient size, liquidity is capable of offsetting most economic risks.

That may increasingly be the case for EM asset classes.”