By Stefan Wagstyl
Published: April 6 2011 19:33
Emerging markets have had a strange start to the year. After a logical decline following the outbreak of Middle East turmoil in mid-January and the oil price surge, equities and foreign currency bonds have staged remarkable recoveries.
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With Brent crude oil above $120 a barrel, up 30 per cent since January, and given the violence in Libya, the Ivory Coast and elsewhere, the 6 per cent rise in the MSCI index of emerging market equities and more than 1 per cent gain in the JPMorgan EMBI+ index of EM bonds looks surprising.
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Fears, too, about inflation in China, India, Brazil and other emerging economies, which stalked the market three months ago, are at least as strong as they were.
So are worries about what might happen in EM equities and bonds when the US Federal Reserve ends its QE2 – quantitative easing – programme in June and reconsiders the ultra-low interest rates policy in place since December 2008.
With so much bad news around, why are emerging markets assets doing so well – and where might they go next?
Kevin Daly, EM debt portfolio manager at Aberdeen Asset Management, the UK-based fund management group, says: “We had negative sentiment in emerging markets at the start of the year. But it was perhaps too negative . . . What matters now, of course, is what the normalisation of interest rate policy [in the US] will mean. There are risks for all risk assets, including emerging market assets.”
Underlying the general nervousness behind Mr Daly’s remarks are two views. The bears argue that emerging markets are riding for a fall, with the recent rally only preparing the way for a bigger sell-off later in the year.
Alain Bokobza, asset allocation head at Société Générale, the French bank, says: “EM assets are currently priced for perfection. With their underlying situation worsening, they look set to be a clear casualty of the end of QE2.”
EPFR, the fund flows research company, estimates that $46bn poured into emerging market equities after the Fed announced QE2 in November and $12bn into emerging market bonds. Since February, $15bn has left emerging market equities, a sign of the change in sentiment, and of the great volatility of these flows. Bond ouflows have been much lower at $1bn.
More bullish observers do not expect a repeat of 2010, when emerging market equities rose 16 per cent, comfortably beating the developed world on 10 per cent. But they argue that the outlook need not be disastrous.
The bears say the oil price could stay high, adding to the inflationary pressures that are already plaguing emerging economies and putting pressure on prices in the developed world – thereby forcing central banks to bring forward interest rate rises.
Such conditions could make it more difficult for the authorities in emerging markets to avoid a hard landing as they try to cut inflation without harming economic growth. China, with its property boom, is a case in point. Brazil, where the government has resorted to capital controls to try to limit inflation-boosting inflows, is another.
Less pessimistic analysts say that, even after the recent rally, EM assets are not expensive, with the price/earnings ratio on EM equities at close to 13.3, compared with above 15 in mid-2010. Given the long-term economic prospects of the emerging world, that is not high. While some countries, such as India, suffer from high oil prices, others, notably Russia, benefit.
Also, say the optimists, with the recovery in the US by no means secure, the Fed will not rush to raise interest rates. So it makes sense to remain invested in emerging markets. Even if the overall returns are not spectacular, there should be stock and currency-picking opportunities.
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Nick Chamie, strategist at Canada’s RBC, says: “We switched from bullish to bearish in December 2010. We have now decided to go neutral and we see two-way risks going forward. We should expect widening differentials between countries and markets.”
For many investors, the key issue remains the US. If America recovers quickly, the Fed may raise rates faster than expected, triggering a potential rush out of risk assets, including emerging markets, and into dollars. US monthly payroll numbers, an important indicator politically as well as economically, will be closely watched.
But if the recovery is weak, tightening may be delayed – to as late as mid-2012 in the view of Christian Keller, a regional head of emerging markets research at Barclays Capital. “It’s one thing for analysts to predict policy normalisation [rate hikes] and it is another for investors to actually bet money on it,” he says.
David Lubin, head of emerging markets economics at Citigroup, the US bank, agrees that the Fed’s actions will be crucial. In 2004, the central bank managed a cycle of interest rate increases smoothly, without upsetting emerging markets. But abrupt action by the Fed in 1994 helped trigger Mexico’s 1996 financial crisis.
It is not just a matter of Ben Bernanke’s skills. The chairman of the Federal Reserve will doubtless be planning for a smooth outcome. But, like others, he is at the mercy of events. And, with the Middle East in trouble, there is no shortage of events.
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Copyright The Financial Times Limited 2011
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