Big Fish, Small Pond?

May 9, 2012

It’s the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem — the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.

But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.

These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets.  In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.

But change is on its way. MS surveys show most classes of global institutional investors intend to boost allocations to emerging markets, including the more conservative investor groups — Japan’s $1.3 trillion government pension insurance fund, for instance, plans to start buying emerging equities later this year.  MS analysts calculate allocations to emerging markets could rise 3.5% over the next five years.

That may not sound like much until one realises the true scale of the global pool of investable institutional assets and compares them with current market cap values in developing countries . These assets currently exceed $212 trillion, meaning a 3.5 % allocation increase will bring over $2 trillion into emerging markets. That’s over half the capitalisation of EM equity market, more than 80% of bond markets and a third of the combined market cap of both sectors.

Take a look at some more numbers:

— Based on current market values, a 1% increase in allocation to EM by pension and insurance funds represents a $524 billion flow to EM assets.

— A 1% increase in allocations to EM fixed income by U.S. pension funds would represent a $170 billion flow. An increase in allocation by US pension funds by 3.3% – the average European allocation to EM fixed income — would represent a $572 billion flow.

— A 1% increase in allocation by sovereign wealth funds/central bank FX reserves would bring in $63 billion flows to EM assets.

–A 1% increase in allocation by private wealth portfolios to EM would represent a flow of $427 billion.

If all this indeed comes to pass, that would truly lead to a Big Fish Small Pond scenario. Morgan Stanley analysts write:

Ultimately we expect a supply response, alleviating the supply/demand imbalance but even with projected growth in supply, absorbing the flows might be a challenge at least in the next 2-3 years.

The change should be mutually beneficial. Emerging assets typically provide higher yields and returns, a boon to Western and Japanese pension investors suffering from an increasingly large asset-liability mismatch. For emerging markets, the inflows will boost liquidity and allow companies and governments to raise funds more easily (and cheaply).

The supply response will likely foster greater development of the market, particularly for the corporate bond market in local currency, we believe. In time it should also mitigate external financing risks for EM economies. (Morgan Stanley writes)

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