A slump in emerging market confidence has led to $1T in capital outflows over the past 13 months, roughly double the amount that fled during the financial crisis.
The sustained exodus of capital highlights concerns that developing economies, suffering slowing growth and weakening currencies, are relinquishing their longstanding role as locomotives to become a drag on demand instead.
New Jersey's $76.8B pension fund cut its holdings of emerging market ETFs to less than $1.8B as of March 31, according to filings compiled by Bloomberg. As recently as 2009, EM holdings were about zero, but rose to over $3B by the end of 2012.
New Jersey's souring on a poor trade could be happening just as emerging markets are showing signs of rebounding following their worst relative performance last year in more than a decade. The MSCI emerging markets index (ETF: EEM) is up 10% since February 5, as is Vanguard's FTSE Emerging Markets ETF (VWO) - one of the funds cut back on by NJ.
New Jersey has company: In the last five quarters through March, investors have pulled $12B from Vanguard's $44B VWO and $12.8B from BlackRock's $36B EEM. The funds, however, have seen inflows of $4.6B since the end of March.
If this is a Fed-tightening-induced selloff, it's got to be the first one in which emerging markets are rallying. The broad iShares MSCI Emerging Markets ETF (EEM +0.5%) has now caught up to the S&P 500 YTD. Leading the charge is continued huge move in Brazil, where the Bovespa is up another 2% today, helping the iShares S&P Latin America 40 ETF (ILF +2.1%) sharply higher.
The iShares MSCI Brazil ETF (EWZ +3%) - ahead nearly 25% since the start of February - is now up 6.3% YTD. Behind the rally is the idea that the year-long string of rate hikes has maybe one more boost left in it.
Investors “are selling emerging markets which have very low valuations, significant dividend yields but have underperformed in recent times ... [for developed markets] which have relatively high valuations, potentially limited long-term earnings growth and where markets have just gone up rather fast," says Sam Vecht, a portfolio manager at BlackRock Emerging Europe Trust.
Mostly bearish on emerging markets in general and Turkey in particular over the past years, Vecht and team have turned bullish in the past few months, citing low valuations and high interest rates (high rates can go lower; zero rates can't).
Suffice it to say these sorts of things don't happen at tops. Brevan Howard Asset Management is reportedly shuttering its emerging market fund after it lost 15% last year, and fund manager Geraldine Sundstrom is exiting the firm.
Brevan Howard is Europe's largest hedge fund firm, with more than $40B in AUM. Its flagship Master Fund - opened in 2003 - has never had a losing year, but had a lame 2013, up just 2.6%. The emerging markets fund opened in 2007 and has $2B in AUM.
In order to draw the necessary capital to pull emerging markets out of their swoon, real interest rates have to go higher, says Citigroup. A near-doubling of the benchmark rate in Turkey last week only pulled one-year borrowing costs up to 3.6%, less than half the average in the thee years prior to 2008. The real yield in Mexico (EWW) is about zero. In South Africa, it's 1.4% vs. 2% over the past decade.
“When you have low real rates and try to finance your current-account deficits, it usually won’t work,” says Citi LatAm strategist Dirk Willer. “If the U.S. is repricing for higher rates, it’s very difficult for you to get away with lower rates. South Africa (EZA) and Turkey (TUR) are not safe yet.”
Good news for contrarian bulls on emerging markets - global emerging markets equity funds saw $6.33B of outflows this week, the fastest pace of exit on record, with institutional investors accounting for $5B of that figure.
"We expect emerging market equities to form a base over the next few weeks, and eventually have a better year," says UBS, the team's optimism coming from a belief emerging market economies will generate solid growth in 2014.
Earnings will be key, says UBS, noting EPS growth has collapsed since 2010, but a pickup to low double-digit growth seams feasible this year thanks to better GDP growth, currency weakness, and margin expansion. Trading at 10.1x forward earnings, EM equities are cheap.
Favorite countries: China (FXI), Korea (EWY), Mexico (EWW), Peru (EPU), Hungary (GUR, ESR).
“International monetary cooperation has broken down,” says India central bank boss Raghuram Rajan, a day after the Fed boosted the size of its taper and made no mention of melting-down emerging markets. Rajan joined counterparts from Turkey and South Africa this week in boosting rates to try and stem the slide in their domestic currencies.
"The challenge is brought on by their own domestic policies," says former Fed Governor Randy Krosner. "It's unfair to say it's all the Fed's fault."
Back in his IMF days in 2011, Rajan authored a report calling for the formation of a committee composed of representatives from the major central banks who would report on the spillover consequences of their individual policies. Good luck with that one.
Emerging markets are getting a respite today amid a big rally in the West (of the West is rallying because of a respite in emerging markets).
The FOMC statement is "completely anodyne" from the U.S. point of view, says Citi's Steven Englander, but as far as emerging markets go it's "hasta la vista, baby." He notes the economic assessment was a hawkish surprise, with economic growth described as having "picked up" rather than "expanding at a moderate pace ... Look to the yen, Swiss franc, and euro to do well, [and] commodity currencies and emerging markets to do poorly."
The MSCI Emerging Markets Index (ETF: EEM) is off 22% from a peak set about three years ago, with the most recent slide coming as currencies tumble. Central banks have begun hiking rates to combat, with India overnight boosting its benchmark for the third time in six months and Turkey expected to take action today (an announcement is due at 5 ET). The South African central bank meets tomorrow, but a rate hike is not necessarily on the table.
As usual, the unwinding of an epic credit bubble in China and the effect on growth tops the list of fears. One trust product - the China Credit Trust - narrowly avoided default this week thanks to a mystery third-party rescue.
Buy the dip, says Ashmore head of research Jan Dehn. “There is some serious dumbing down going on in financial markets right now when it comes to EM. EM debt levels (especially external debt), EM’s general reliance on external markets, and EM’s reserve holdings have all improved beyond all recognition over the past 10 years.”
Loomis Sayles' Peter Marber: “Compared to 1998, emerging markets hold over $7T more in hard currency reserves to cushion themselves from market volatility. For most emerging markets, the problems today are nothing like the problems of the mid-1990s. Very few countries are near default, and those that may be are relatively small.”
The iShares Emerging Markets Index ETF (EEM) is off 1.3% in the premarket as investors rush out of emerging currencies. The Turkish lira plunged to a record low today, while Ukraine's hryvnia fell to a four-year low, and South Africa's Rand dove to its weakest since October 2008 following Argentina's decision to devalue the peso and a weak PMI report out of China yesterday.
“We continue to see the risks surrounding China’s macro trajectory as having a negative impact on EM,” says Morgan Stanley's Rashique Rahman. “As capital costs rise and investment slows, commodity prices should come under pressure, boding poorly for economies linked to China’s old growth model.”
Of Turkey from Rareview Macro's Neil Azous: "Their net foreign-exchange reserves are dwindling pretty fast. They’re definitely in the danger zone. If you’re a money manager, the responsible action is to take some measures to reduce risk.”
You could have made the same bear case against emerging markets 10 years ago and you would have missed a decade of outperformance, says Everest Capital chief Marko Dimitrijevic, rebutting Goldman's recommendation to cut holdings in the sector. "If you reduce or ignore emerging markets, you're going to miss on literally hundreds of companies that are great."
Overall, Dimitrijevic overall return estimates are just slightly higher than Goldman's, but the real alpha is to be made in specific sectors - education in Brazil, infrastructure in Mexico, retail, cement, oil and gas in Colombia, and consumer plays in Saudi Arabia.
Everest is most bullish on frontier markets, or, as Dimitrijevic calls them, "EM 2.0." "It's a secular opportunity that reminds us very much of what now-mainstream emerging markets were like 15 or 20 years ago."
Everest had a big year in 2013, gaining 41.2%. Its dedicated Frontier fund rose 28.8%.
Emerging markets may seem cheap, but now's not the time to boost holdings, says Goldman in a report titled: Emerging Markets: As The Tide Goes Out. Those with a "moderate" tolerance for risk should cut exposure by a third - from 9% to 6% - says the team.
The fast growth in EM from 2003-2007 was the result of a mix of economic circumstances not likely to be repeated, says Goldman. Instead, there's been a "seismic shift" in sentiment as returns were not as attractive as expected, growth rates were not as sustainable as imagined, and countries were not as stable as believed.
It's worth paying another 50 or 60 basis points in expenses for a good ETF product not tracking a vanilla index, says RiverFront Investment's Rod Smyth at a Barron's ETF roundtable. One favorite in emerging markets is PowerShares' FTSE RAFI Emerging Markets Portfolio (PXH) which tilts towards factors like book value and cash flow and offers bigger weighting to sectors like energy. Bullish on Japan, his pick is WisdomTree's Japan SmallCap Dividend Fund (DFJ). Another favorite is PowerShares' FTSE RAFI Developed Markets Ex-U.S. Portfolio (PXF).
Ron Rowland offers additional highlights on the recently expanded lineup of commission-free ETFs over at Fidelity including the following caveat: Funds not held for 30 days by retail investors or 60 days by RIAs using Fidelity as a custodian will be subject to a $7.95 per-trade commission. Some RIAs have complained that the longer holding period directed at them is unfair. Rowland spells out the full list of affected ETFs here. Mar. 18, 2013, 4:57 AM