Asiamoney: Where money goes next after emerging market debt

Asiamoney, July 2013

For many years, emerging market bonds have been in great demand among global investors hungry for yield. But throughout 2013, talk of a bubble had been getting louder – until in June, comments by the US Federal Reserves about tapering its quantitative easing program changed everything. $15 billion was pulled out of emerging market mutual funds and ETFs over the next two weeks, according to EPFR Global, and more may follow it to the exits.

At the same time, emerging market equities – already considerable laggards compared to developed world peers – have fallen still further while the US S&P 500 has hit record highs. By June 16, the MSCI EM stock market index was down 9.6% year to date.

So what does this all mean for high net worth investors in Asia? There are a few themes to consider: whether emerging market debt has become overvalued; how those assets will react when quantitative easing really does come to an end; and what alternatives investors have when they’re looking for yield.

To take the first, opinion is divided. “We do not think there is a bubble in emerging market debt, particularly in Asia,” says Ben Sy, head of fixed income at JP Morgan Private Bank in Asia. “There are, though, some technical headwinds due to the rapid growth of the asset class and weaker liquidity.” The emerging market corporate hard currency bond market capitalization – which basically means dollars – grew from $605 billion in 2009 to $1.1 trillion in 2012, he says, with new issuance reaching $330 billion in 2012 alone as investors sought yield and issuers rushed to provide it.

A positive reading is that recent reversals therefore represent a buying opportunity. “EM bonds have significantly underperformed developed market credit” because of supply, volatility and weaker liquidity triggered by fears about tapering by the Fed, Sy says. But Asian credit, he says, has held up relatively well versus the CEMBI Broad index, which covers emerging market debt globally: Asia is down 1.1% in the year to date, compared to 1.8% for the broader index. “Emerging market investment grade spreads now trade 107 basis points wider than developed markets, which is attractive from a valuation perspective and should narrow over time.”

Another positive view is that the expansion in emerging market debt does not represent a bubble but a change in the way corporates are borrowing. “Yes, the market has grown tremendously in recent years, but at the expense of the syndicated loan markets,” says Kelvin Tay, regional CIO at UBS’s wealth management division in Singapore. “A lot of companies are trying to manage their capital structure better and rely on the debt markets more than the loan markets. The debt levels have not really gone up that much.” Net debt to equity on corporate balance sheets in Asia has risen from 18.3% after the Lehman collapse to 26% – an increase, but far lower than the 41.8% level in 1990 and far below the 90% level it hit in the financial crisis, he says. Asian issuers are underpinned by better national numbers too, with total ex-Japan Asian foreign exchange reserves now standing at 52% of world GDP compared to 24% a decade ago. Consequently, Tay agrees with Sy that recent reversals can create an opportunity. “The recent sell-off is overdone and you should be able to get some value there on a selective basis,” he says. “Some yields have shot up very sharply. If you manage duration well, it’s a pretty interesting.” He cites some Singapore dollar and RMB denominated securities in particular, though he does add: “in terms of duration, you’ve got to be careful. I would propose nothing longer than five years.”

Others do think there is a bubble, and that recent developments only hint at much worse to come. “I think there is a risk, certainly,” says Rogerio Bernardo, director on the bond syndicate desk at RBS, speaking before the worst of the recent outflows took place. “If US Treasury yields start to rise it will put a lot of pressure on fixed income funds and hurt a lot of portfolios. The bubble is certainly there and we could see a rapid shift away from fixed income assets if base rates are rising.”

This concern is not unique to Asia, and certainly not limited to dollar assets. Charles Robertson, global chief economist at Renaissance Capital, pointed out last month: “I’m told Ukraine has seen the issuance of 10 corporate dollar bonds so far this year, Rwanda’s 10-year debut bond came in below 7% yield despite its single B rating, and Nigeria’s 2021 dollar bond yields 4%. What we are now getting very close to is a local currency bond bubble too.” For example, he said local bond flows into Turkey went from $223 million in January and February 2012 to $4.53 billion in January and February 2013 – a 20-fold increase in a year.

And if markets have reacted like this at the mere suggestion that the Fed might taper, what on earth happens when it actually does? “The initial part will be negative,” says Tay. “It’s like a drug. If you’re hooked on something and scale back, no matter how much or little you scale it back you’re going to get some cold turkey.” But that doesn’t mean it has to be painful in the long term. “It all depends on how fast the Federal Reserve tapers the balance sheet, and how it does it. If it says it’s not only going to stop buying bonds but to shrink by $85 billion a month then that’s going to be a disaster for everyone, now just emerging markets. But that’s very, very, very unlikely.” His own call is that tapering will begin in December or January, which is roughly a quarter later than the majority expectation, and that US Treasury yields will stand at 2.2% by the end of the year, which is exactly where they are at the time of writing.

Additionally, he argues that there are forgotten benefits to higher rates and yields. “A more normalised yield curve is pretty for healthy for Asia, particularly the banking sector,” he says. “We are coming from an environment of negative real yields now. Singapore and Hong Kong have a huge deposit base, and any increase in yields is going to be positive for those banks and their margins.”

And rising yields will presumably mean a healthier US economy. “Historically, a recovery in the US economy is good for emerging markets,” Tay says. “We [Asia ex-Japan] are the biggest supplier of goods and services to the US, and many countries here have their currencies pegged to the US dollar.” There’s little sign of an improved US economy helping Asia yet – of export numbers from Korea, Taiwan and Singapore, only Korea has looked positive, which is perhaps partly because of efforts to reduce the value of its currency in competition with a devaluing yen – and Tay says the US recovery has to spread from the housing market to consumers before any knock-on effect will be felt in Asia. “It will come eventually. The omens are there but we need another 12 months before this transmission mechanism will work.”

Sy suggests that when QE does end, it’s going to affect a lot more than just emerging markets debt. “The eventual withdrawal of quantitative easing and the normalisation of interest rates should result in the re-pricing of all risky assets, not just fixed income,” he says. “The property sectors in Asia have seen significant asset price inflation due to the record low interest rates and ample liquidity, and that is prone to a meaningful correction if the Fed tapers its asset purchases. Given that a significant proportion of the wealth of HNWIs in Asia is linked to the property sector, the impact of QE withdrawal may have a profound impact on their net worth.” His view differs from Tay’s on the impact on banking. “Investors with substantial leverage positions in financial investments may be negatively impacted by higher funding costs and lower asset prices.” The answer, he says, is a balanced approach towards investments by asset class and geography.

Still, he doesn’t think that recent reversals in emerging market assets generally represent the start of a longer trend, instead arguing it is driven by technical reasons. “We believe the growth of the EM asset class is secular, and the continued growth of EM economies and wealth will support demand over the longer term.”

But when equities are brought into the discussion, that does become more of a minority position. “I’ve been negative on emerging versus developed equities, especially the US, since the autumn of 2010,” says John-Paul Smith, global emerging market equity strategist at Deutsche Bank. “For me it’s a multi-year underperformance cycle and we are, at best, halfway through it.”

Maarten-Jan Bakkum, senior emerging market equity strategist at ING Investment Management, agrees. “We are now two and a half years underperforming, and it’s quite a surprise that a lot of people are still excited by emerging markets,” he says. A continuing slowdown in China – he predicts a decline to 5% growth there within three to five years – and a lack of reform and structural change in emerging markets, certainly compared to the developed world, are “two reasons to believe emerging markets will continue to struggle,” he says.

And although emerging market GDP growth rates are higher than in the developed world, there is the momentum question to consider: major Asian states are slowing while the US is increasing. HSBC’s benchmark emerging markets index for May, compiled from PMI indices, stood at its joint lowest level since September 2011, demonstrating a slowdown in emerging market economic growth. “It’s a mixed picture,” says Pablo Goldberg, global head of EM research at HSBC in New York, “but it’s true that on a growth basis, emerging markets are entering a cyclical slowdown,” reflected in weaker emerging market equity performance than developed world peers.

Neil Shearing, chief emerging markets economist at Capital Economics, agrees a cyclical shift is taking place. “We’ve got used to this period whereby emerging market growth continued to strengthen and the developed world started to struggle,” he says. “The tables have turned a little, certainly since the start of the year.” Partly this is a consequence of the considerable improvements in the US economy, and rising optimism about Europe. “But data from emerging markets has been disappointing, really: we saw growth slow through the first half of 2012, and though it picked up in the second half, it then started to slow again.”

Shearing attributes the worsening emerging markets numbers to weaker growth in Latin America and in all four BRICs, as well as weaker growth in emerging Europe. “There are a few parts that seem to be doing quite well – Africa, southeast Asia – but by and large there is a broadbased decline.” And the BRICs will drive momentum and sentiment, he says, “because these four economies have been responsible for about a quarter of global GDP growth over the last decade, but each of them are now running into structural problems and are going to have weaker growth over the next decade.”

“I’m not forecasting doom and gloom, but weaker growth in BRICs is enough to shave half a percentage point off global GDP,” he says. “When you consider global growth is so weak in the first place, that’s significant.”

Many fund managers believe that equity exposure is much better taken in the developed world, particularly the US, than emerging markets. Frances Hudson, global thematic strategist at Standard Life in Edinburgh, favours the US because of better economic fundamentals, and signs of recovery in the housing market and consumer spending. She is neutral on emerging market equities – “if what you’re trying to get is emerging market growth, you’re better off investing in the currencies or bonds” – and underweight developed Asia.

An overweight position on the US is also recommended at UBS. “On a short term basis there’s no doubt the US equities market will outperform,” says Tay. “That is still where we favour putting money in, largely in mid and small caps: they tend to reflect the domestic economy more than the big cap stocks, which are exposed to global growth and which may not be fantastic in the near term.” UBS is underweight bonds overall, but overweight high yield selectively.

What to conclude? There may be worse to come in the short term in attitudes towards emerging market assets, and the more the market believes that tapering is just around the corner, the worse it is likely to be. But beyond that, the longer term arguments around emerging markets – higher growth economies, demographic sweet spots, lower sovereign debt – are still intact. High net worth investors with an emerging market conviction may just have to be patient.