Global Investing

Political risks appear to be rising in emerging markets, but how do you measure them?

Protests in Egypt – leading to the ousting of a second president in as many years-  Turkey and Brazil have caught investors on the hop this year, causing the kind of market volatility that emerging market bulls had been saying were a thing of the past.

Political risk didn’t go away, so it turned out, it just took a breather, while at the same time spreading to countries like Portugal and Greece.

Market players often use credit default swaps as a proxy for political risk, as they measure a country’s likelihood of defaulting on its debt. Egypt’s five-year CDS hit record highs earlier this week following mass demonstrations, but they fell on Thursday after the army removed Islamist President Mohamed Mursi, as investors hoped for a more business-friendly environment.

But investors find CDS a clumsy and risky tool, that can be easily influenced by other factors, like liquidity or the credit quality of your counterparty. Renaissance Capital measures per capita GDP against government type since 1950 to show the similarities between Egypt in 2013 and Turkey in the 1970s, before Turkey’s 1980 military coup, which was followed by democratic elections only three years later:

For an investor in emerging equities the best strategy in recent years has been to take a contrarian stance, says John-Paul Smith at Deutsche Bank.

Smith, head of emerging equity strategy at Deutsche, has been bearish on emerging stocks since 2010, exactly the time when bucketloads of new cash was being committed to the asset class. Investors who heeded his advice back then would have been in the money — since end-2010 emerging equities have underperformed U.S. equities by almost 40 percent, Smith pointed out a couple of months ago.

Things have worsened since then and MSCI’s emerging equity index is down around 12 percent year-to-date, almost the level of loss that Deutsche had predicted for the whole of 2013. June outflows from emerging stock funds, according to EPFR Global last week, were the largest on record. But true to form, Smith says he is no longer totally bearish on emerging equities.  Maybe the presence or absence of those he calls “marginal international investors” — people who joined the EM party too late and are quick to take fright — is key. Many of these positions appear to have been cleaned out. Short positions or high cash balances dominate the books of dedicated players,  Smith writes:

The South Americans are dominating possession. And it’s not only on the football pitch.

Net flows at Brazilian equity mutual funds have been positive for 11 out of the 12 months to end-May, according to estimates from Lipper, leading to total net inflows over the period of about $13 billion. That stands in stark contrast to the other three BRIC emerging market powerhouses.

China equity funds have waved goodbye to almost £3 billion in that time, Russia a similar amount and India $4 billion. India equity funds have seen 12 straight months of net outflows, Russia 10 out of 12 and China nine out of 12. The graphic below makes the trend clear, with Brazil the only BRIC to show net inflows to equity funds in eight of the 12 months examined. (A brief note on India: the reporting timetable of locally-domiciled funds means that these numbers are largely from funds based outside the country, which account for about half of assets)

Glass half full or half empty? For emerging markets watchers, it’s still not clear.

Last month was a record one in terms of net outflow for funds dedicated to emerging equities, Boston-based agency EPFR Global said.  Debt funds meanwhile saw a $5.5 billion exodus in the week to June 26, the highest in history .

These sound like big numbers, but in fact they are relatively small. EM equity funds tracked by EPFR  have now reversed all the bumper year-to-date inflow registered by end-May, but what of all the flows they have received in the preceding boom decade?

It’s starting to look like investors in Britain’s top companies have reverted to type.

Reuters ran the numbers on voting at FTSE 100 annual general meetings (AGM) last week and you would be forgiven for thinking the ‘shareholder spring’ had never happened. The average vote against executive pay deals at the 71 top companies which have so far held their AGM was down 18 percent from the result for the full FTSE 100 in 2011. The raw number has to be viewed with caution; investors claim victory in forcing companies to engage, cut absolute pay and tweak bonus arrangements, even though there is little direct evidence so far of pay moderation in absolute terms.

The protest vote fell or stayed put at 58 percent of companies and there was little other evidence of acrimony when you look beyond pay votes. If we exclude a clutch of votes over the rather arcane issue of notice periods for general meetings, then more than two thirds of companies suffered no protest vote of 10 percent or more on any other AGM resolution.

What goes in, can come out. And the more that goes in, the more than can come out. That’s what emerging economies have been finding out in recent weeks as capital flees their stock and bond markets.

Take the case of Russia. It’s decision last year to allow foreigners to access its domestic bonds more easily led to a boom in its OFZ or rouble debt, market, with many analysts reckoning OFZs could receive inflows of almost $50 billion in 2013-2014.

Analysts at RBS calculate some $24 billion was received in the past 18 months by OFZs but in the words of outgoing central bank Governor  Sergei Ignatyev, recent outflows have been “very heavy”. Yields on Russia’s 10-year bond have jumped 120 bps since early June.RBS analysts write

Recent wild swings in Japan’s financial markets — stocks, bonds and the yen — make Japan look almost like an emerging country.

Back in the 19th century, Japan was an emerging country, with its feudal society based largely on farming.

According to a paper by U.S. based researchers Chiaki Moriguchi and Emmanuel Saez, Japan’s GDP per capita in 1890 was at the level of U.S. GDP per capita in 1790, or about $1,200 in 2004 dollars. According to them, this is roughly comparable to the GDP per capita of the less developed countries today.

Speculation is growing that new central bank governor Elvira Nabiullina will cut rates to help stimulate faltering growth soon after takes up her job later this month, but the resilience of the Russian consumer may be another important factor in giving the economy a lift.

Retail sales figures have been lower than expected for the first quarter of 2013, leading economists to revise downwards their prediction for this driver of growth, though performance in the construction and cement sectors is improving, according to Morgan Stanley research:

Overall, we estimate that household consumption growth has accounted for 65 percent of Russian growth over the last decade.

Turkey’s lira, South Africa’s rand and South Korea’s won have all lunged, local currency debt yields have suddenly surged, there’s an intense investor focus on domestic political risks again and governments like Brazil who were taxing what they feared were excessive foreign investment over the past couple of years have U-turned as those flows evaporate. 

What some have feared for many months may well be materializing – a ‘sudden stop’ in financing flows to emerging markets as the makings of a perfect storm gathers. With the Fed mulling some reduction in the amount of dollars it’s pumping into the world, the prospect of a rare and protracted rise in the dollar and U.S. Treasury yields potentially changes entire EM investment metrics for U.S. funds (who make up almost half of the world’s private institutional investors) and from markets which have willingly or not been some of the biggest beneficiaries of QE in recent years but also to where where , by some estimates, nearly $8 trillion of FDI and portfolio flows have flowed over the past decade. It doesn’t even have to mean a reversal of capital already in emerging markets, but even a sudden stop in new flows there could seriously undermine the currency and debt markets of countries heavily dependent on rolling foreign financing – those with large current account gaps to finance. As emerging and global economic growth has eased and return on equity sinks, emerging equity markets have already underperformed for three years now. But the biggest wave of recent investment in EM had been into its bond markets, most recently to higher-yielding local-currency debt markets. And it’s these flows that could dry up rather quickly and shockingly, with all the attendant pressure on currency rates and vice versa. For context, a record of more than $410 billion new sovereign and corporate bonds from emerging economies were sold last year alone, according to JPMorgan, and Morgan Stanley estimates show emerging companies alone have sold some $130 billion worth of new debt so far this year – up 30 percent on last year and more than twice the same period in 2011.
               Already we’re seeing big hits to big current account deficit countries Turkey and South Africa in this region and, as is so often the case in emerging markets, the withdrawal of capital leads to an intense focus on domestic and political risks. These are two of the five biggest destination for bond flows over the past four years, a list –measured on flows as share of GDP – also includes Poland and Czech Republic. Mexico is top of the list, but many see its geographic and financial proximity to the US insulating it.

               So, is this a 1997/1998 redux? That’s certainly a big fear. The similarities are obvious – building dollar strength, higher US Treasury yields and a repatriation of US investment to a domestic ‘emerging market’ (Silicone Valley and the dot.coms in the late 1990s); a sharp drop in Japan’s yen which upset the competitive landscape in Asia; narrowing global growth differentials; some signs of excessive monetary easing in emerging economies and concern about credit bubbles in China and elsewhere; the sudden magnifying of domestic political, social and policy risks etc etc.

The dog that didn’t bark was how the IMF described inflation. But might the fall in emerging market currencies reverse the current picture of largely benign inflation?

Nick Shearn, a portfolio manager at BlueBay Asset Management, sees the rise in inflation as not an if but a when, which makes inflation-linked bonds (linkers in common parlance) a good idea. These would hedge not only against EM but also G7 inflation — he calculates the correlation between the two at around 0.8 percent. He says linkers outperform as inflation uncertainty increases, hence:

As a result of the loose monetary policies of recent years that have been implemented to promote growth within emerging market economies, we believe rising as well as persistent inflation should become a trend….. Currently we are seeing the early signs of an inflation dynamic in isolated countries such as in Brazil. But, as inflation begins to rise across the region, inflation uncertainty will also begin to rise and consequently inflation-linked bonds should perform well.