Bubble fears as emerging markets soar. The question now is not about emerging economies’ strengths: they have proved their resilience, not least in the 2008-09 crisis. It is whether investors have got carried away in chasing these prospects.
Hogging still going on "say the bulls, the investment world lags behind reality. While emerging economies now account for more than 30 per cent of global GDP, US, European and Japanese financial institutions have between them only about 2-7 per cent of their $50,000bn of assets in the emerging world.
Points to emerging market skyrocketing without US, European and Japanese financial institutions
Bubble fears as emerging markets soar
By Stefan Wagstyl and David Oakley in London
Published: October 7 2010 20:45 | Last updated: October 7 2010 20:45
How long will the party last? On the one hand, World Bank and International Monetary Fund officials warn of the dangers of too much money rushing into emerging markets. On the other, fund managers pile into these countries, driving their currencies and markets to post-crisis peaks.
As the dollar has tumbled against emerging counterparts this week, Robert Zoellick, World Bank president, has talked of currency “tensions” and “the risk of bubbles”. The IMF, in its global financial stability report, said: “The prospect of heavy capital inflows would be destabilising.”
Stock markets, though, especially those of south-east Asia, are not listening. Instead, they are soaring. Indonesia, the Philippines and Colombia have hit all-time record peaks this week. Brazil and India are trading not far short.
Key emerging market currencies are up, too, with India’s rupee, South Africa’s rand and the Brazilian real at post-crisis highs. The Thai baht is at a 13-year peak. Bonds are bringing up the rear among emerging market financial assets, but the spreads over US government debt are tight. The JPMorgan EMBI+ index of US-dollar denominated bonds is trading at about 275 basis points over Treasuries, against 900 during the crisis.
The question now is not about emerging economies’ strengths: they have proved their resilience, not least in the 2008-09 crisis. It is whether investors have got carried away in chasing these prospects.
The bulls say that if these economies are growing fast, so will the returns they generate. Nigel Rendell, senior strategist at RBC Capital Markets, says: “Investors are still switching into emerging markets across asset classes because they are expected to grow much more strongly than in the developed world. That’s the real driver – and that will last for a decade.”
In equities, the MSCI emerging market stock index trades at around 13 times forecast 2010 earnings, or 11 times 2011. This is in line with their five-year average and just short of the 14 times on which US stocks now trade.
Jonathan Garner, of Morgan Stanley, says: “I don’t think anyone can claim that emerging market equities are in a bubble, as valuations are fair. The markets may have risen sharply since the summer, but the market was looking cheap then.”
In bonds, the most widely-followed indicator is the JP Morgan EMBI+ index, which is now trading at around 275 basis points above US Treasuries. This is well down from its crisis peak of 904, but is still a bit short of its pre-crisis low of 146.
Brett Diment, head of emerging market debt at Aberdeen Asset Managers, says: “Clearly, you can’t make the same kind of returns as you would have if you had bought bonds six months or a year ago, but they still look like good bets.”
All this is supported, say the bulls, by currency appreciation, driven by trade performance and investment inflows, which boost the relative prices of emerging market assets compared with the developed world. Catch-up in currencies reflects catch-up in economic development.
Furthermore, say the bulls, the investment world lags behind reality. While emerging economies now account for more than 30 per cent of global GDP, US, European and Japanese financial institutions have between them only about 2-7 per cent of their $50,000bn of assets in the emerging world.
Even allowing for the fact that emerging economies have far smaller financial markets, there is still scope for huge asset re-allocation.
Figures from the International Institute of Finance, the bankers’ club, show how confidence in these arguments has grown since the spring. The IIF this week sharply raised its forecast for capital inflow into emerging economies from an April prediction of $709bn to $825bn.
For the IMF, fund managers’ habits are the core of the problem: with a powerful herd instinct, they tend to move together and risk swamping markets with their buckets of money. As the Fund’s report says: “Investor flow data suggests emerging markets tend to suffer from herding behaviour.”
Moreover, as the Fund points out, the global economy remains in a fragile condition, with big debts and deficits overhanging the developed world. So, the bulls’ arguments that today’s valuations are in line with those of 2005-10 may not be valid. The world economy wobbled badly in 2008-09 and has yet to find a new point of balance.
A key driver of investor behaviour is the prospect of another round of “quantitative easing” led by the US and Japan. For the bulls this is bullish – there will be lots of cheap cash to invest. For many bears it is worrying – QE risks triggering instability and inflation.
Abdallah Guezour, an emerging market bonds fund manager at Schroders, the UK asset management group, says that while quantitative easing will support demand for emerging market currencies for a while, the “aggressive printing of money globally won’t change the underlying situation in western economies but will generate bubbles, perhaps in 12-24 months.”
Timothy Ash, head of emerging markets strategy at the Royal Bank of Scotland, is a bull who has turned a little bearish. He recently told beyondbrics, the FT’s emerging markets online hub: “These are generally still poor countries with weak institutional structures, huge levels of income inequality, political fissures, difficult business environments and high levels of corruption.
“I am still not sure that these factors are now being priced in: the gush of developed market QE is blinding us to the risks?.?.?.?A new bubble is being inflated. It probably hasn’t yet reached a level of leverage which risks being pricked, but once we see signs of growth and inflation again in the G7+ the downside risks will be immense.”
For the moment, the momentum of the markets is with the bulls. But if it turns for any reason – and the world is not short of such reasons – the correction could come swiftly. |
