Aberdeen Standard Investments Ltd. and Nomura Holdings Inc. have a word of caution for investors marvelling at the relative resilience of emerging debt markets in last week’s global selloff: the worst is still to come.
They argue that the turmoil that shook up global stock markets was a symptom of a paradigm shift, from an environment that favors developing markets, to one which doesn’t. As inflation concerns push up bond yields and unwinding stimulus tests liquidity, the risk assets that have enjoyed a torrent of inflows in recent years could be in for a shock.
Along with other high-yielding assets, emerging markets have been the darlings of the so-called “goldilocks” environment of excess liquidity and low volatility, with bonds and equities attracting more than $150 billion of inflows last year. While that was in part supported by rising growth in developing economies, it won’t be enough to sustain inflows, according to James Athey, a senior investment manager at Aberdeen.
“What I see for the world in front of us is a vastly changing investment environment,” said Athey, whose firm has about $431 billion under management. “Last week was the first time we had a glimpse of what the new world might be like.”
Athey is keeping his global bond portfolios low on emerging-market risk and shorting some currencies such as the Brazilian real. Analysts at Nomura also sounded the alarm bells in a recent note, saying they are concerned about a “painful snapback” when developed-world central banks start shrinking their balance sheets more rapidly toward the middle of the year.
One early-warning indicator they are keeping an eye out for is developed-market growth momentum starting to slow while inflation keeps rising. Another is a sharper widening of emerging-market corporate credit spreads, which would send a significant amount of Asian “dead wood rising to the surface.”
“The simple point is that just as QE was successful in pushing global investors into riskier higher-yielding EM assets, the unwind of QE will have the opposite effect,” the Nomura analysts including Rob Subbaraman said. The effect of the unwind will probably be more non-linear “because of the large build-up of EM debt and how quickly market liquidity can evaporate,” they said.
Morgan Stanley is more upbeat, arguing that the bullish case for emerging markets holds as long as the dollar continues to trade near a three-year low and U.S. real yields aren’t much higher. Analysts at the bank including James Lord recommended buying emerging-market local-currency bonds in a recent note to clients.
The direction of the dollar is one thing that could make or break the outlook for emerging markets, according to Athey, who is in a minority of investors betting the greenback will strengthen. His view is that increased bond issuance from the U.S. Treasury and the unwinding of the Fed’s balance sheet will withdraw liquidity from the system, pushing up the currency.
The greenback’s drop has helped offset pressure from rising Treasury yields on emerging debt markets in recent months, while supporting local-currency assets and pushing up prices of the commodities many developing nations rely on for export revenue.
“The fact that the dollar has been going sideways and even weakening really does underpin everything,” Athey said. “This is less about fundamentals, the economy, growth and inflation. We’re seeing the previous paradigm beginning to go into reverse now.”
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