27four Investment Managers
4th February 2014
Is this another emerging market crisis?
A recent report from US fund tracker EPFR Global showed that outflows from emerging market equity funds surpassed $6.3bn last week. This was the biggest outflow from these funds in three years in terms of a percentage of assets under management.
When you are talking these sorts of numbers, it is a big story. The markets are clearly worried about emerging markets as US bond yields rise, China’s manufacturing sector looks under pressure and political concerns refuse to go away.
But just how big a story is this likely to be? Are we headed for something like the Asian crisis of 1997-1998, when emerging markets fell like dominoes?
South Africa’s personal experience is that the country saw massive foreign outflows from bonds in January, with a record of close to R23bn being withdrawn over the month. And while there was net foreign buying of equities on the JSE for the first half of January, that turned to selling in the second half.
John Cairns from the global markets research team at RMB believes that this is probably consistent with what is happening across emerging markets, particularly those known as the “fragile five” – South Africa, India, Indonesia, Brazil and Turkey.
But while this does represent a huge loss of confidence in emerging markets amongst retail investors, one that has become self-sustaining as panic bred more panic, he sees it as a short-term reaction.
“There is a huge amount of literature that suggests that 2014 should still be a good year for fund flows,” he says. “All the IMF studies on what drive capital flows still show that emerging markets remain attractive.
“What are we going through right now is a loss of confidence, but it appears that this is mostly retail investors that are panicking while institutional investors are maintaining their positions. A recent report from Morgan Stanley even suggested that institutional investors plan to increase their holdings this year.”
Fatima Vawda, Managing Director at 27Four Asset Management, agrees.:
“I don’t think there are going to be any massive surprises in the market,” she says. “Two years ago, when we were worried about Cyprus and EU contagion, anything could happen. But there’s no room for those kind of big surprises now.”
She adds that the 27Four Pangea Africa Fund of Funds has not seen any outflows, although the fund does serve long-term institutional investors who can withstand bouts of volatility.
Stephane Bwakira, manager of the Sanlam African Frontier Markets Fund shares a similar view:
“We haven’t seen any outflows in our fund either, but I think there has been a tactical shift in asset allocation around emerging markets and frontier markets,” he says. “The heightening of US interest rates and the slowdown in Chinese manufacturing have impacted on the global perception of emerging markets.”
And while the scale of the outflows shouldn’t be ignored, Cairns is confident that we are not heading for a repeat of the late 1990s.
“Markets are panicked, and in that panic they are prone to overshoot. But this is highly unlikely to be a crisis of the scale of 1997 and 1998,” he says.
He also argues that South African investors need to be aware of what the real issues are behind the sell-off and the impact it is having on the local currency.
“It has nothing to do with the strikes, it is a loss of confidence in emerging markets in general,” he says. “There has been speculation that markets could short the rand and go long on the lira or another currency, but we have seen no evidence of this. So South Africa is not a leader in what is happening, it is merely a follower, and that is what is feeding through into the rand.
“The question really is whether Turkey’s aggressive rate hike and the aggressive action from other central banks has been enough to stop the rot. For the last four sessions it has been, but the markets are still on edge.”
27Four’s Vawda also points to important factors that make this sell-off different to the 1997-1998 experience.
“That crisis was very different to what is happening now,” she says. “If we look at the contribution to world GDP of emerging markets, it was 5-10% in 1997, but now its 40-50%. China’s economy has grown bigger than Japan’s.
“You also have emerging markets contributing 15-20% of earnings of S&P 500 companies. Growth in all the big branded shares like Microsoft, Apple and Pfizer has also been largely due to emerging markets. So any slowdown there is going to affect them as well.
“I think that the impact on the US market would also be quite significant, and so the US Fed won’t operate in a vacuum. It will acknowledge the volatility of emerging markets, and their policies will be tuned to accommodate the impact on these markets and the effect that will have on their own.”
For RMB’s Cairns, there are two major differences between the current scenario and what happened in 1997-1998.
“Very few emerging markets are now running currency pegs,” he explains, “which means that their currencies can act as a shock absorber. And, secondly, there is the lack of original sin. With the growth of domestic bond markets, companies in emerging markets have been able to raise finance locally and are no longer reliant on dollar funding. So the risk of a currency depreciation – capital loss spiral is reduced.”
However, he does add that this good news still comes with three warnings.
“Firstly, in all previous emerging market crises a lot of problems that we didn’t know were there crept out, so who knows where more problems may lie? Secondly, all emerging market crises have come at times of US Fed policy tightening. And thirdly, emerging market crises tend to erupt after local elections, and South Africa, Turkey, Brazil, India and Indonesia are all in election years.”
But as Sanlam Investment Management’s Bwakira says, the story in many emerging markets is still fundamentally positive, particularly in Africa.
“The consumer is still going strong in Africa and the revised GDP growth rate’s from the World Bank and IMF seem to be quite good,” he says. “There is also still a commodity story on the continent, which is attractive. There have been no real earnings revisions for 2014 and 2015, but we do still have to see what the full impact is going to be.”
Vawda also still believes in that there is room for exposure to Africa in any portfolio.
“In the broader scheme of things, having exposure to frontier markets gives you important diversification,” she says. “Africa is still an exciting region, mostly because it is the last frontier for growth. And West Africa, East Africa and North Africa are the regions driving returns.”
For South Africans though, there is a direct impact of all of this market uncertainty. As Cairns explains, the effects on the rand are telling.
“The problem is that outflows generate currency weakness, which forces the Reserve Bank to hike interest rates. And there will be more hikes to come,” he says.
“But once markets stabilise you should see, in South Africa in particular, a currency snap-back. We are predicting R10.20 to the dollar at year end, but that doesn’t rule out R13.00 to the dollar in the interim.”
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