In the last week of May, Emerging Portfolio Fund Research (EPFR) – a data provider on investment fund flows – reported that there had been net outflows of capital from emerging market equity and debt funds. While net emerging market equity outflows have become more frequent since February, the disinvestment of close to USD3 billion over the final week of May is the largest in recent memory. Perhaps even more significant was the outflow from emerging market bond funds– the first time this has occurred in about a year and a sharp turnaround from a persistently strong run of sizeable net inflows over the past two quarters. While this is only one week’s worth of data, the unusual synchronous exit of portfolio wealth from emerging markets raises some serious questions.
First, how significant is the vulnerability of emerging market assets to changes in the global macroeconomic environment? After all, the most important development in global financial markets in recent weeks has been the reassessment of how quickly the US central bank may begin to wind down its asset purchase programme. There is palpable nervousness about how even small changes to the provision of global liquidity from the Fed may impact demand for assets that have been the beneficiaries of unconventional monetary policies and the associated reach for yield.
There is a substantial body of macroeconomic-financial literature available to help assess how well founded this nervousness might be. A timely contribution to this was presented at the end of May at a Euro Area Business Cycle Network (EABCN) conference hosted by the Banque de France. In the paper ‘Institutional Investor Flows and the Geography of Contagion’, Damien Puy (European University Institute) considers the forces driving portfolio flows. A few of the inter-related findings of this study are of particular interest when considering emerging market portfolio flows, especially emerging market debt.
- Portfolio dynamics at a microeconomic-level have macroeconomic-level consequences;
- ‘Push’ factors dominate ‘pull’ factors;
- International fund flows are strongly pro-cyclical.
The first highlights how features of the institutional investment industry can cause substantially more contagion across asset markets than would be justified by real economy (or even financial) linkages. This is occasionally called ‘the portfolio channel of contagion’, with emerging market assets being relatively more vulnerable. Indeed, this feature has potentially never been as significant: portfolio inflows into emerging markets in recent years, and the associated rise in proportional foreign ownership, are unprecedented. This can be seen in foreign bond purchases in Mexico since the second quarter of 2009, which cumulatively surpassed 14% of GDP. Although this is an extreme example, the same phenomenon can be seen in other emerging market debt markets.
The second incorporates the assertion that debt portfolio flows to emerging markets remain far more dependent on global developments than regional or local ones. Taken together, these suggest that an awareness of the correlation between emerging markets and their collective sensitivity to global, non-emerging market specific developments is very important.
The third embodies the idea that capital flows tend to be synchronised with global economic and financial conditions. With the elevated involvement of developed market capital in emerging debt markets, an increased heterogeneity of the investor base would seemingly promote greater two-way interest within previously localised markets. In turn this would allow for idiosyncratic market developments to become relatively more important and individual emerging debt markets to be less impacted by global economic and financial developments. However, this appears not to have occurred – international fund flows towards emerging markets remain positive during reflationary periods, but turn negative otherwise. And the greater level of foreign investor involvement potentially makes emerging market debt more vulnerable during downturns in global confidence, but conversely well placed to benefit from a global upswing.
We continue to expect a modest improvement to the global outlook in the second half of 2013. Therefore, increased optimism towards emerging market debt in anticipation of this may be justified. However, given that the bulk of this improvement is expected to be provided by the US, there may be a timing issue that complicates matters somewhat. While real economy strength in the US would feed through into emerging markets more broadly, there is always a lag. If there are limited drivers of global growth elsewhere doing the heavy lifting, relative growth differentials between the US and the rest of the world would narrow, potentially for a meaningful period. Even if this skew in the global growth profile is temporary, it seems an unlikely cyclical backdrop to support strong inflows into emerging markets debt; although this would depend on how sustainable the US recovery was believed to be and how much of this uplift might be shared with the rest of the world.
The underlying message is one of enhanced vigilance in the near term. While this type of analysis has little to say on the medium to longer-term fundamental attractiveness of emerging market debt markets, it does provide a word of caution in the near term. Equally, if the weakness currently experienced by many risk assets and driven by changing expectations of the Fed’s monetary policy stance persists, the ensuing undiscriminating withdrawal of international capital from local markets could open up highly attractive opportunities in emerging market debt – above those of most other asset classes.