Emerging Markets will see outflows as risks rise

Emerging markets have been the surprise disappointment of 2013. What happened in the first half of 2013 was a remarkable divergence between emerging markets and the US Dow Jones Index. Most emerging markets lagged the Dow by more than 20%; rarely has asset allocation between mature and emerging markets mattered quite so much. Few people thought that running a big bet against the US – gaming against the global benchmark – could go so spectacularly wrong.

Many investors – both private and institutional – were just beginning to get more comfortable with investing directly in developing economies. These seemed to offer soundly financed growth when Western economies were struggling. Now it looks as if investors misunderstood the risks and that the reality did not match the story.

Being taken in too readily by plausible stories is a psychological bias that distracts us from clinical analysis. In this case, it is that the risks in emerging markets are growing. Compounding the problem, many global fund managers also went underweight the US market in the search for growth and performance.

US recovery looks entrenched

The real risks of that strategy are now evident. The US is the single economy that has moved into steady recovery, sorted out its bank sector and can soon move to printing less money than others. It might have a large deficit, but much progress has been made in improving competitiveness and the dollar remains the world’s reserve currency.

Fund managers gaming higher risk markets against a global benchmark that is dominated by the US will need to reset their risk models. Volatility of the US market, measured by the Vix, is near a five-year low.

After the banking crisis, emerging markets actually looked safer. Banks in emerging markets were not over-extended, and many countries were running large budget surpluses. Typically this was the result of high prices for oil, metals and other commodities.The lower US dollar also helped businesses based in emerging markets to access cheap finance for growth by borrowing dollars. The boom fed on itself.

The catalyst was China’s boost to growth by raising infrastructure spend. Only now is it clear that China’s sustainable trend growth rate is likely to be lower. That boom fuelled unproductive spending, creating bubbles in shadow banking, commodities and property. Now that the bubble is clear, China is moving to unwind its excesses.

This will involve redirecting its economy to lower growth and a focus on consumption. By contrast, the US economy is rebounding more strongly than most expected. Emerging markets and commodities might have hit oversold levels at the end of June, triggering a bounce, but there could be more pain to come as the year progresses.

A tapering of US quantitative easing could highlight the divide between the US and the rest. Managers are likely to unwind their gaming against the global benchmarks and increase US allocations at the expense of smaller markets. Representativeness means our analysis is often thwarted by appearances. The emotional image of a high growth economy conveys the idea of high growth shares.

Yet history shows relatively little correlation between stock market performance and economic growth. Chinese shares were so overvalued five years ago that investors have lost money, despite strong economic growth over the period.

Investors must also factor in currencies and politics. Asian currencies have experienced sharp devaluations this year, offsetting stock market gains for international investors.

Social unrest in countries such as Egypt, Greece, Turkey and Brazil is also a factor in the risk/reward calculation. Now that the supply of US dollars is being squeezed globally, many emerging economies – including India, Brazil and Turkey – are burning through foreign exchange reserves to defend their currencies. Interest rates are also being raised, but devaluations may be inevitable. Leveraged emerging market businesses, such as utilities, face much more expensive funding costs.

Investors are reassessing the risks. Clearly many have been too trusting of the growth story, failing to understand the true nature of emerging economies and how relatively young their democracies are. Global funds that have been under-exposed to the largest markets now face pressure to increase investment in the US and Europe. The next chapter in the emerging markets story is about to unfold.

A version of this article was published on Citywire Wealth Manager on August 6th 2013

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