Low market volatility spurred a “torrent” of capital flows into emerging-market debt, reflecting investor complacency and “excessive risk taking,” Bank of America Merrill Lynch strategists led by David Hauner in London wrote in a report last week. He warned that the second half of the year should bring challenges for lower-rated issuers as higher interest rates in the U.S. reduce some of the appeal of junk credits with relatively steep interest rates.
“The market is at a point where we haven’t hit a real bump in the road to wake everyone up.”
And they are not alone. Since entering the world of emerging markets nearly three decades ago, Robert Koenigsberger, who oversees $6 billion as chief investment officer at Greenwich, Connecticut-based Gramercy Funds Management, has seen more than his share of changes. One of the most consequential, BloombergQuint.com reports, is the migration of allocators from hedge funds to exchange-traded and mutual funds in recent years.
That’s effectively made ETFs one-day liquidity vehicles, versus the 90-day instruments leveraged funds typically offer, which, as Koenigsberger explains simply means:
"This market isn’t well set up for outflows."
Which is a big problem, because, outflows are accelerating...
As JPMorgan recently noted...
What caused this deterioration in EM overall capital flows in Q2? It is difficult to answer this question given that current account data are not available for Q2 for most EM countries. But if one uses high frequency data of fund flows such as equity and bond ETF flows as proxies for overall portfolio flows, we find portfolio flows were not responsible for the deterioration in the overall EM capital flow picture in Q2. Both EM equity and EM bond fund flows were rather strong in Q2 and if anything there was acceleration in EM equity fund flows relative to Q1.
As a reminder, in the run-up to this dumping of EM assets, expected uncertainty in Emerging Market Equities has never been lower... (in fact EEM implied vol is now less than half its lifetime average of 29.7%)
What was even more stunning than investors' tolerance for these risky issuers is how little compensation they’re demanding in return. Emerging Market bonds were pricing in the least 'risk' since Dec 2007...
The disconnect is a result of historically low interest rates worldwide -- notes in Japan, Germany and France have negative yields -- as well as what skeptics see as investors’ complacency as they pour into index-based funds without scrutinizing their holdings.
“I’m guessing the alarm bells are ringing, and in many ways it feels like 2007,” said Anders Faergemann, a senior fund manager in London at PineBridge Investments, which oversees about $80 billion globally.
“Dedicated EM investors are dancing ever closer to the exit door, but for those of us who were around in 2007 there was a long period in which EM continued to rally even though valuations were stretched.”
However, as Bloomberg notes, the Federal Reserve’s hawkish posture (though tempereed modestly last week) sets the stage for an uptick in developing-nation volatility in the second half of the year, Bank of America Merrill Lynch strategists said.
And that is among the things that Koenigsberger fears... (via BloombergQuint.com)
"We’re potentially sitting on one of the most illiquid market conditions in emerging markets that I’ve ever seen..."
"This market showed its stripes in the taper tantrum, and I think this will challenge the taper tantrum, if not 2008."
Since the global financial crisis, the amount of emerging-market high-yield debt has quadrupled to about $763 billion, according to data compiled by JPMorgan Chase & Co. At the same time, dealer inventories have been scaled back to about a fifth of what they were in 2009 due to regulations, Koenigsberger said, meaning many banks no longer participate in emerging markets as intermediaries or proprietary traders.
"The question is: Is this a market or a bazaar?" Koenigsberger said.
"In 2017, with the absence of banks providing liquidity, who will facilitate the flows for the one-day ETFs and mutual funds?"
One wonders if those liquidity issues are about to appear front-and-center, as the lagged effect of the collapse in China's credit impulse is set to send volatility and risk spreads higher...
The fickel flows into, and now rushing out of, EM debt, seem to have finally woken up to the reality that, as Bloomberg's Lisa Abramowicz notes, the fundamental health of emerging markets has deteriorated on average, with the debt of lower-rated countries such as Turkey, Ecuador and Sri Lanka accounting for a greater proportion of benchmark indexes. As Bloomberg Intelligence's Damian Sassower and Alexander Graf noted in a recent research note, leverage is on the rise among high-grade, nonfinancial corporate and quasi-sovereign issuers in emerging markets. And investors are getting compensated less for the increasing debt relative to income of these issuers.