Emerging Markets: Risky and Rising
Emerging markets are drawing, perhaps, an unfair comparison with California these days. Fund managers from the affluent West are busy scouring the corporate landscape in places set as far apart as Saigon and Mumbai, in the hope of finding that proverbial pot of Gold. This does not mean that they will ultimately find one. But atleast they are trying.
Two centuries ago Spanish conquistadores and white settlers ravaged the hills of San Francisco and the adjoining San Fernando valley, in the search for Gold. Some struck it rich and those lucky few sprung forth the richest families of the United States-those like the Rockefellers, the Morgans and Openheimers control everything from railroads to banking to insurance, even today.
That success, however, does not denote today's California. The State is known as much for its sun, sand, snow and deserts as for the singular economic force that drives the US economy.
Should fund managers strike it rich in the emerging markets, they may end up creating for the Emerging nations...an economic force as strong as the Californian miracle..Amen.
The Institute for International Finance in September increased its estimate of portfolio flows into emerging markets by 10% for the current year--57% higher than in 2003--while prices of emerging market assets have risen due to high demand. The move into emerging markets is due to a combination of push forces--making developed markets less attractive--and pull forces associated with improvements in emerging markets. This is particularly important for dollar-based investors who are still the dominant force in global portfolio investment.
Several factors have encouraged bond and equity investors to take more risk in credit markets and in emerging markets:
Carry Trade: The main push factor is the decline of the "carry trade" in U.S. government bonds this year. The investment strategy is to borrow money at the short end of the market and invest it in maturities further out along the curve, picking up the spread between the two yields. It has been a popular trade for investors who can use a lot of leverage, such as banks and hedge funds. However, the Treasury market has seen a doubling in Fed rates to 4% this month from 2% in November 2004. As a result, the pickup in yields from Fed funds to five-year Treasury bonds has fallen to 0.5% from 1.3%, making the trade less attractive.
Expensive Markets: Dollar-based investors have been looking elsewhere for value in equity markets as developed equity markets have become considerably more expensive outside of the United States.
Credit Downgrades: Traditional credit borrowers have suffered difficulties due to pressures on profit margins from emerging market competitors, and the growing stress of their pension and medical liabilities from their large retired workforces. The resulting credit downgrades have made emerging markets look even more attractive as an alternative.
There are three pull forces in favor of emerging markets:
Growth: Economic growth has been rapid in the last few years, especially in Latin America where growth has increased to 5.7% in 2004 and 4.3% this year from 1.7% in 2003. Also, the current-account positions of many countries have improved. Domestically, budget deficits and financing needs have shrunk while market-friendly policies have improved the economic outlook. Rapid growth has also improved corporate profitability, attracting foreign direct investment (FDI) and portfolio flows.
External Debt: Emerging market borrowers, especially governments, have been able to take advantage of tightening credit spreads to restructure their borrowings. This has reduced their costs and balance sheet vulnerability, allowing them to finance their external borrowing needs more easily and lengthen the maturity of their debt.
Institutional Factors: Institutional forces are making it easier for investors to invest in emerging markets. Local stock markets are larger and more transparent, while a greater number of local firms are listing on Western markets. The rating agencies have given a number of governments investment credit status, removing restrictions on how much debt can be held below investment grade.
For emerging markets, the best type of investment is equity investment, whether direct or through share purchases. FDI is preferred as it represents a long-term commitment, while equity portfolio investment can help local firms raise long-term funding. In contrast, fixed-income investments tend to be short term, whether done by banks or investment funds.
There are two possible dangers to investors in emerging markets:
* Credit Problems: Current indicators of credit quality in developed markets are still strong, but the credit cycle may be peaking. There is little scope for further gains since credit spreads are especially low in historical terms, making leverage more difficult.
* Emerging Markets: Despite more transparency and flexibility, many emerging economies remain vulnerable. In particular, a further rise in oil prices would severely damage growth prospects for many oil-importing emerging economies, which have failed to make significant progress in raising energy efficiency.
Emerging markets--especially in the Asia-Pacific region--continue to attract large amounts of long-term equity finance from the private sector. While investment opportunities in developed markets have diminished, the deteriorating credit cycle is likely to affect portfolio investors who are increasingly investing in emerging markets.
Originally posted by Rajiv Handa
