How Low Do We Go Before EM Buyers Bite?

LONDON (IFR)—Is the emerging markets sell-off overdone? Just as investors got too enthusiastic about EM debt in the fourth quarter of last year and first of this, pushing yields and spreads ever tighter, the pessimism now hanging over the asset class is equally too extreme, say some bankers.There's no big default on the horizon, despite deteriorating fundamentals in some countries, no balance of payments crisis that's requiring the urgent attention of an IMF worried about regional contagion, and investors continue to sit on plenty of cash waiting for the right moment to step back in. "Yes, there's shock and panic, but one ought to keep a cool head," said Nick Darrant, head of CEEMEA syndicate at BNP Paribas. "The market is very dynamic. In two weeks time we don't know where it will be. These aren't door numbers, markets move around." Every emerging markets index is down for the year with the EMBI Global, which tracks hard currency sovereign debt, leading the way. The index has lost 5.30 percent in the year up to June 11, as worries about when the U.S. Federal Reserve will begin to slow down its asset purchase program have intensified, triggering an aggressive jump in Treasury rates. That, in turn, has led to a fierce sell-off in risk assets, especially emerging markets. Since May 22, the spread on the EMBI Global has widened 70 basis points, which on top of a 65-bp spike in 10-year Treasury yields, means the all-in yield has risen 1.35 percent in a little over three weeks — a very sharp move. The panic has spread to other emerging markets asset classes too, with JP Morgan's GBI-EM index, which tracks local currency government bonds, down 7.5 percent in May. Countries with domestic political problems and big current account deficits, such as Turkey and South Africa, have particularly struggled, as have liquid markets dependent on foreign inflows, such as Mexico. Even JP Morgan's CEMBI Broad index, which tracks corporates including high-yield, and which should, therefore, be less correlated to Treasury yield movements, is in negative territory for the year. It is down 2.68 percent, in line with the performance of the 10-year U.S. Treasury, according to Thomson Reuters. "This sell-off has been long in coming. I think most investors knew that emerging markets had been propelled along by QE in developed markets to levels at which prices did not reflect the fundamentals of the emerging market country concerned," said Timothy Ash, head of emerging markets research ex-Africa at Standard Bank. Investors, however, say the price falls need to be put into historical context, pointing out that the experiences of 2008 and the second half of 2011 were much worse. Many, in fact, say the correction is a necessary process after the markets got too frothy. "The moves are significant but a healthy reminder that prices can go up and down," said Stephen Yeats, senior investment manager at State Street Global Advisors. "What we are seeing is a re-pricing of certain risks." It's the abruptness of the gyrations rather than the general upward direction in itself that is causing some investors to panic. While the market has been expecting rates to rise since January, it's the spike in the 10-year yield from 1.65 percent in early May to a high of 2.37 percent earlier this week that lies behind the big price falls. "Instead of a gradual rates rise and people getting accustomed to that and pricing it in, we've seen a sudden spike with bonds dropping 10 points. It takes a long time to recover from that," said William Weaver, managing director and head of CEEMEA debt capital markets at Citigroup. Low Yield Risk With yields having ground tighter for emerging markets credits over the past few years, a 10-point price drop means big mark-to-market losses for investors. In 2000, for example, Turkey issued a 30-year bond at 11.875 percent. Even if the bond's cash price fell 10 points, investors were getting sufficiently compensated by the coupon. But Turkey's most recent benchmark deal was a 10-year note that came with a 3.25 percent coupon. The bond, which priced at 98.093, is trading at 92.245 on the bid side, according to Thomson Reuters. Investors will no longer be able to post positive returns by just clipping the coupon, and will be nursing painful net losses. Potentially compounding the problem is that most emerging markets investors rarely hedge their rates exposure as the strategy brings its own risks. If the Treasury market suddenly turned around and everyone piles in again, then investors would be long risk and short Treasuries and lose both ways. Value Bets With Qatar '30s above 4.5 percent, Philippines '21s at 3 percent and Brazil '24s around 4 percent, one trader reckons certain assets are starting to appeal. Investors started to dip their toes back in on Wednesday [June 12] after a brutal Tuesday [June 11] with high-beta credits in particular, such as Ukraine, benefiting. And despite the EMBI Global being on course to record only its third negative year since 1995 — the only other two years are 1998, after the Asian and Russia crises, and 2008, following the onset of the global financial crisis — analysts are confident the asset class's performance can turn around in the second half. Joyce Chang, global head of the emerging markets research group at JP Morgan, still expects the index to achieve a positive return by the end of the year, albeit of just 1.1 percent, which would still be a dismal performance compared with last year's 18.5 percent. Ms. Chang recognizes that fixed income has "clearly hit an inflection point," but argues that "it is still possible to generate returns in excess of 5 percent in EM fixed income from current valuation levels for the remainder of the year, and we are prepared to be tactical in our recommendations once we feel that the market technicals have settled." As a consequence of the sell-off, outflows from emerging markets funds have accelerated. The week ending June 5 saw $1.52 billion of redemptions from hard and local currency accounts combined. While that outflow is largely retail-driven, the doomsday scenario is that institutional investors will follow suit, leading to a vicious spiral of tumbling prices, exaggerated by illiquid secondary markets and further redemptions. So far, a disorderly market breakdown has not taken place, and again context is important. Despite the outflows of recent weeks, year-to-date inflows stand at $35.3 billion, according to JP Morgan, which reckons the year will end with $70 billion of inflows. Indeed, cash is king right now. Cash balances have increased by 0.3 percentage points to 3.4 percent over the month, according to JP Morgan's most recent EM client survey. That money will eventually need to be invested. But everything comes back to rates. "Is this THE definitive move in U.S. rates, i.e. is there more upside pressure on U.S. Treasury yields?" asked Mr. Ash. It's the $2.7 trillion question for the EM fixed-income market. By Sudip Roy