Global Investing

The people buying emerging markets

We’ve written (most recently here) about all the buying interest that emerging markets have been getting from once-conservative investors such as pension funds and central banks. Last year’s taper tantrum, caused by Fed hints about ending bond buying, did not apparently deter these investors . In fact, as mom-and-pop holders of mutual funds rushed for the exits,  there is some evidence pension and sovereign  wealth  funds actually upped emerging allocations, say fund managers. And requests-for-proposals (RFPs) from these deep-pocketed investors are still flooding in,  says Peter Marber, head of emerging market investments at Loomis Sayles.

The reasoning is yield, of course, but also recognition that there is a whole new investable universe out there, Marber says:

There has been so much yield compression that to get the returns investors are accustomed to, they have to either go down in credit quality or look overseas. Investors have been globalizing their equity portfolios for 25 years but the bond portfolios still have a home bias. We are starting to see more and more institutional investors gain exposure to emerging markets, and a large number of recent RFPs highlight more sophisticated mandates than a decade ago.

The allocation swing has been especially marked since the 2008 crisis and subsequent Fed money printing that flattened yields across developed markets – the IMF estimated earlier this year that of the half trillion dollars that flowed to emerging bonds between 2010-2013, 80 percent came from big institutional investors.

Here is a chart provided by the Institute of International Finance that shows the stark contrast between retail and institutional investors’ emerging market holdings:

Indian shares: disappointment may lurk

Should Indian shares really be at record highs?

The index is up 3.6 percent this year. Foreign funds have been pouring money into Mumbai shares, betting that the opposition BJP, seen as more reform-friendly than the incumbent Congress, will form the next government. They purchased $420 million worth of Indian stocks last Friday, having bought $1.4 billion over the past 15 trading sessions.

There is also the fact that the rolling crisis in emerging markets, having smacked India during its first round last May, has now moved on and is ravaging places such as Russia and Nigeria instead. The rupee has firmed almost 2 percent this year to the dollar, as last year’s 6.5 percent/GDP current account deficit has contracted to just 0.9 percent of GDP.  Many international funds such as Blackrock and JPMorgan Asset Management have Indian stocks on overweight and Bank of America/Merrill Lynch’s monthly survey showed investors’  underweight on India was one of the smallest for emerging markets.

Indian company earnings may have beaten forecasts by around 5 percent so far in the season. But prospects can hardly be described as attractive. Indian economic growth is running at less than 5 percent. Valuations are in line with historical averages and at a 4 percent premium to global emerging markets on a book-value basis. But John-Paul Smith at Deutsche Bank says it is “the least bad” of the BRICs and is neutral to overweight.

Waiting for current account improvement in Turkey

The fall in Turkey’s lira to record lows is raising jitters among foreign investors who will have lost a good deal of money on the currency side of their stock and bond investments.  They are also worrying about the response of the central bank, which has effectively ruled out large rate hikes to stabilise the currency. But can the 20 percent lira depreciation seen since May 2013 help correct the country’s balance of payments gap?

Turkey’s current account deficit is its Achilles heel . Without a large domestic savings pool, that deficit tends to blow out whenever growth quickens and the lira strengthens . That leaves the country highly vulnerable to a withdrawal of foreign capital. Take a look at the following graphic (click on it to enlarge) :

In theory, a weaker Turkish lira should help cut the deficit which has expanded to over 7 percent of GDP.  Let us compare the picture with 2008 when the lira plunged around 25 percent against the dollar in the wake of the Lehman crisis. At the time the deficit was not far short of current levels at around 6 percent of GDP.  By September 2009 though, this gap had shrunk by two-thirds to around 2 percent of GDP.

Value or growth? The dichotomy of emerging market shares

Investors in emerging markets are facing a tough choice. Should one buy cheap shares in the hope that poor corporate governance and profitability will improve some day? Or is it better to close one’s eyes and buy into expensively valued companies that sell mobile telephones, holidays and handbags — all the things high-spending emerging market consumers hanker after?

At the moment, investors are plumping for the latter, growth-at-any price investment strategy. Result: a lopsided emerging equity index in which consumer discretionary shares are up more than 5 percent this year, energy shares have lost 7 percent while MSCI’s benchmark emerging equity index is down 3 percent.

All markets have their share of cheap and expensive. But the dichotomy in emerging markets is especially stark. Analysis by Bank of America/Merrill Lynch of the biggest 100 emerging market companies revealed last week that the 20 most expensive stocks in this bucket are trading 11 times book value and 31 times earnings (both on trailing basis) while forward earnings-per-share (EPS) is seen at almost 30 percent. The top-20 companies all belong to the private sector and most are in the consumer-facing industries.  This year they have gained more than 50 percent.

Pakistan, Nigeria, Bulgaria… the cash keeps coming

The frontier markets juggernaut continues. Here’s a great graphic from Bank of America/Merrill Lynch showing the diverging fund flow dynamic into frontier and emerging equity markets.

What it shows, according to BofA/ML  is:

Frontier market funds with year-to-date inflows of $1.5 billion have decoupled from emerging markets ($2.1 billion outflows year-to-date)

In other words, frontier fund inflows since January equate to 44 percent of their assets under management (AUM), the bank says.

No more currency war. Mantega dumps the IOF

Brazil’s finance minister Guido Mantega, one of the most shrill critics of Western money-printing, has decided to repeal the so-called IOF tax, he imposed almost three years ago as a measure to fend off  hot money flows.

Well, circumstances alter cases, Mantega might say. And the world is a very different place today compared to 2010. Back then, the Fed was cranking up its printing presses and the currency war (in Mantega’s words) was raging; today the U.S. central bank is indicating it may start tapering off the stimulus it has been delivering. Nor is investors enthusiasm for emerging markets what it used to be.  Brazil’s currency, the real, is plumbing four-year lows against the dollar and local bond yields have risen 30 basis points since the start of May. Brazil’s balance of payments situation meanwhile, is deteriorating, which means it needs all the foreign capital  it can get, hot money or otherwise. And currency weakness spells inflation — bad news for Brazil’s government which faces voters next year.

The IOF did work — Brazil’s local debt markets received just over $10 billion last year, Bank of America/Merrill Lynch calculates — a third of 2010 levels, and much of the cash that was already invested, preferred to stay put (given the IOF is paid upon exiting the country).

Emerging European bonds: The music plays on

There seems to be no end to the rip-roaring bond rally across emerging Europe.  Yields on Turkish lira bonds fell to fresh record lows today after an interest rate cut and stand now more than a whole percentage point below where they started the year.

True, bonds from all classes of emerging market have benefited from the flood of money flowing from central banks in the United States, Europe and Japan, with over$20 billion flowing into EM debt funds since the start of 2013, according to EPFR Global. Flows for the first three months of 2013 equated to 12 percent of the funds’ assets under management.

But the effect has been most marked in emerging European local currency bonds — unsurprising, given economic growth here is weakest of all emerging markets and central banks have been the most pro-active in slashing interest rates.  Emerging European yields have fallen around 50 basis points since the start of the year, compared to a 20 bps average yield fall on the broader JPMorgan index of emerging local bonds, Thomson Reuters data shows.

Will gold’s glitter dim in India?

Indians have reacted to the latest gold prices falls by — buying more gold. And why not? Aside from Indians’ well known passion for the yellow metal (yours truly not excluded) gold has by and large served well as an investment: annual returns over the past five years have been around 17 percent, Morgan Stanley notes.

Now, gold’s near 20 percent plunge this year has wiped some $300 billion off Indians’ gold holdings, Morgan Stanley estimates in a note (households are believed to own about 15,000 metric tonnes of gold). So is the gold rush in India over?

Possibly. Indian gold imports have doubled to around 3 percent of GDP in the past five years. That rise is partly down to greater wealth which translates into more wedding jewellery purchases. But the more unpleasant side of the equation is India’s inflation problem. Look at the following charts from MS that shows how negative real interest rates have encouraged savings in gold rather than financial instruments:

No one-way bet on yen, HSBC says

Will the yen continue to weaken?

Most people think so — analysts polled by Reuters this month predict that the Japanese currency will fall 18 percent against the dollar this year. That will bring the currency to around 102 per dollar from current levels of 98. And all sorts of trades, from emerging debt to euro zone periphery stocks, are banking on a world of weak yen.

Now here is a contrary view. David Bloom, HSBC’s head of global FX strategy, thinks one-way bets on the yen could prove dangerous. Here are some of the points he makes in his note today:

–  Bloom says the link between currencies and QE (quantitative easing) is not straightforward. Note that after three rounds of QE the dollar is flexing its muscles. The ECB’s LTRO too ultimately benefited the euro.

Using sterling to buy emerging markets

Sterling looks likely to be one of this year’s big G10 currency casualties (the other being  yen).  Having lost 7 percent against the dollar and 5.5 percent to the euro so far this year on fear of a British triple-dip recession, sterling probably has further to fall.  (see here for my colleague Anirban Nag’s take on sterling’s outlook).

Many see an opportunity here — as a convenient funding currency to invest in emerging markets. A funding currency requires low interest rates that can bankroll purchases of higher-yielding assets including stocks, other currencies, bonds and commodities. Sterling ticks those boxes.  A funding  currency must also not be subject to any appreciation risk for the duration of the trade. And here too, sterling appears to win, as the Bank of England’s remit widens to give it more leeway on monetary easing.

All in all, it’s a better option than the U.S. dollar, which was most used in recent years, or the pre-crisis favourite of the Swiss franc, says Bernd Berg, head of emerging FX strategy at Credit Suisse Private Bank.