October 3, 2014 / 9:12 AM / 5 years ago

EM reaches critical juncture

* Confluence of risks shakes confidence

* Commodity exporters most vulnerable to shocks

* Analysts caution against excessive pessimism

By Sudip Roy

LONDON, Oct 3 (IFR) - Investors are increasingly fretting about the outlook for emerging markets as a combination of market and political risks threatens to derail a successful year for the asset class.

While the total return on JP Morgan’s EMBI Global, which tracks the performance of hard currency-denominated debt, is 7.3% for the year up to September 30, in the two months since August 1 it is -1.2%.

In spread terms, the index is at its widest level since March when the Russia-Ukraine conflict began, having blown out 50bp over the third quarter.

Many recent new issues have struggled to perform in the secondary market with even a recent five-year bond from Abu Dhabi Commercial Bank, which is majority state-owned, down nearly one point.

Analysts say a confluence of risks have left emerging markets at their most parlous state since the so-called taper tantrum of last year. Those risks include the prospect of tighter US monetary policy, a strong US dollar, slower growth, especially in China, geopolitical concerns in Ukraine and the Middle East, protests in Hong Kong, the upcoming presidential election in Brazil and the departure of Bill Gross from Pimco.

A survey of investors by French bank Societe Generale revealed this week that buyside accounts are “virtually in panic mode”.

“They are more bearish now than they were in late May 2013, the infamous month that kicked off the major EM meltdown last year,” said Benoit Anne, head of EM research at SG.

One DCM banker admitted the backdrop is testing. “It’s a really tough market. It’s a nervous time for EM Who knows what will happen next?”

The real fear is if investors try to exit all at once, given the disparity between the amount of funds now invested in the asset class and the level of dealer inventory held by investment banks. “The exits are too small, if we ever need them,” wrote Citigroup analysts Matt King and Jeff Williams in a piece called “Tourist traps: How long will the money stay in EM (and credit)?”.

Their note is not one for the faint-hearted, concluding the “whole EM story risks unravelling” as rising yields make it more attractive for foreign investors to stay at home.


The turnaround in sentiment towards the asset class can be traced to the spike in Treasury yields over a three-week period from late August as 10-year rates jumped more than 30bp, peaking at 2.65%, as investors grappled with the imminent end of the Fed’s assets purchase programme and the timing and severity of potential interest rate hikes.

Although yields are back down below 2.50%, the rally in Treasuries is being driven by a general risk-off tone as a series of headlines, such as Gross’s move to Janus Capital and pro-democracy protests in Hong Kong, engender a sense of uncertainty.

One market particularly under the cosh is Brazil. The Real slid some 10% against the US dollar in September as the latest opinion polls suggest incumbent Dilma Rousseff will be re-elected ahead of market favourite Marina Silva.

Brazil is one of the countries identified by Citigroup analysts as being most vulnerable to capital flight and exchange rate pressures thanks to its deteriorating current account deficit and, crucially, its position as a commodity exporter at a time of slowing Chinese growth.

Citigroup believes commodity exporters will be first in investors’ line of fire should they begin to flee the asset class, arguing that the distinction between these countries and countries which export manufactured goods is “the most important fault-line in EM these days”.

“In the [commodity exporters] we see deteriorating terms of trade, worse export performance, wider current account deficits, lower levels of investment efficiency, more depreciated currencies and bigger inflation problems,” the Citigroup analysts said in a separate research note - this one entitled “Time for another tantrum?”

Still, some analysts don’t believe the general threat to emerging markets is as bad as the anecdotal evidence suggests.

Anne at SG said it’s hard to imagine a similar bloodbath to last summer despite what his clients are saying. “Let’s not panic. Yes, EM investor sentiment is currently quite poor, but as we approach a major transition phase for global markets, it may also be set to be rather volatile. I am still thinking about [global emerging markets] for the bullish side, for now.”

And even if there is a sustained repricing of assets, it is unlikely to be linear. “There will be a tough time in local currency markets [in Asia] in the near term. As the dollar strengthens, carry trades will start to be unwound, but Asia G3 is expected to stay strong,” said one banker.

Investors could also re-allocate money within the asset class rather than flee altogether. “The biggest risk to Asian bonds is if Russia stabilises and Brazil has a good outcome to the election,” said Kaushik Rudra, global head of rates and credit research at Standard Chartered. “Money could move back into those markets.” (Reporting by Sudip Roy (additional reporting by Daniel Stanton); editing by Matthew Davies and Alex Chambers)

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