Investors continue to pour money into the EM asset class. Weekly inflows into EM equity funds remain strong with no sign of let-up. Just look at India, we have already received $23 billion of FII inflows, the highest level ever. Coal India has received a great response, with the institutional portion subscribed 15x, FIIs are scrambling to get an allocation and the money continues to pour in. Investors are rushing to raise weightings in EM stocks, before Fed chairman Ben Bernanke can fully unleash his plans to purchase possibly a trillion-dollar worth of long-term debt instruments and lower long-term interest rates in the US. Given how weak the dollar has been, and this is likely to continue, investors seem to be in a desperate hurry to move out of dollar-based assets. There is a strong intuitive appeal to this trade, the Fed cuts rates and money rushes into EM equities. Investors chase growth, bid up these markets and it all ends ultimately in one big bubble. This trade is the consensus view of how things will unfold, and most money managers are positioned to benefit from and expect further EM outperformance. It looks like a very crowded and one-way trade at the moment.
In this context, a recent note by the EM strategy team at BCA is worth noting as it raises doubts on the inevitability of the above-mentioned sequence of events. It asks the very pertinent question of whether a Fed easing always leads to an EM rally (BCA EMS bulletin, October 19).
The note makes the point that in the early 1990s, emerging market share prices were negatively correlated with the Fed funds rate. Low interest rates in the US drove capital into the emerging markets, where growth was stronger, much like today. The EM equity asset class had a huge run, almost bubble-like conditions and a long-term secular peak were formed in EM equities in 1994-95.This is pretty much what most investors expect to see going forward for EM equities over the coming months.
The note also points out, however, that from this 1995 peak, till very recently, EM equities were actually positively correlated with US interest rates. In this period, EM equities were seen as a call option on global growth and far more sensitive to global growth expectations than interest rates. EM equities actually did better in an environment of rising US rates, as hikes in Fed fund rates reflected strong global growth conditions. Any weakness in global growth actually impacted EM equities harder than any other asset class, with serious consequences for EM relative performance.
In this period (1995 onwards), there were a few divergences between interest rates and the performance of EM equities (wherein the correlation became negative again), but these divergences (in 2001 and 2007) were temporary and not lasting beyond a few months.
The note thus makes the point that investors need to make a judgment call as to whether the current rally in EM equities is a more sustainable bull run like in the early 1990s, or something which will fizzle out soon, similar to 2001 or 2007 when EM equities faltered despite continued declines in US interest rates as global growth weakened. Can EM equities outperform on the basis of liquidity and flows alone, without a pick-up in global growth?
In trying to understand the different reaction function of EM equities to US interest rates pre- and post-1995, one clear difference between the two periods is the external position of EM economies. Prior to 1995, most of the EM economies had current account deficits and an externally leveraged corporate sector, and were thus very sensitive to both cost and availability of external capital. Cheap and easily available credit made a huge difference to many of the larger EM economies and their companies. After the Asian crisis, most of the larger EM countries have a current account surplus or very small deficits, and a corporate sector with little external leverage, thus they do not benefit as much from cheap and easily available financial capital. They are more dependent today on global growth to sustain their exports and current accounts, and maintain economic momentum.
Markets today, however, seem more likely to follow the pre-1995 template (where EMs did well with falling rates). Investors are desperate to get out of dollar-based assets. Many believe that the “new normal” is for a decade or more of extremely low nominal growth rates in the West and EM economies have demonstrated great resilience. Unlike the post-1995 period when global growth was strong and EMs posted superior relative performance, today, except for the EM economies, there is just no signs of sustainable growth. The financial metrics for most EM economies are far superior to the West, with many convinced that most economies in the West have intractable fiscal sustainability and balance sheet issues. Trade within the EM countries themselves has also exploded, giving them greater resilience to an OECD slowdown. Record low interest rates are also driving a mad scramble for yield and returns. If you wish to remain invested in “safe” fixed-income instruments in the West, your returns are basically nothing. There also seems to be a secular and long-term asset allocation shift towards EM assets, much like the early 1990’s when the asset class was first discovered.
Whichever way EM equities trade, there is very little doubt that this is a great environment for India. India has low export dependence and needs global capital to finance its huge investment needs, running one of the larger current account deficits among the major EM economies. This makes India one of the only beneficiaries of today’s environment of very subdued demand among the OECD economies and record low interest rates. The tightening by China will once again put pressure on commodities, further enhancing India’s appeal. India had begun to underperform as commodities began moving higher, but this underperformance should reverse as commodities come off. As India has a genuine inflation problem, it also seems more willing to tolerate rupee appreciation than many other EM central banks, further boosting returns for dollar-based investors. India is in a sweet spot, but just as the beta is high on the way up, so is it on the way down as well. Any change in global risk appetite will impact India disproportionately. The only hope is that given the funk the US finds itself in, liquidity conditions will not reverse in a hurry. Our more domestically oriented economic model and strong entrepreneurship are in fashion. We must use this window of low-cost capital availability to suck in long-term capital, improve the government balance sheet and build out productive assets.
The author is the fund manager and chief executive officer of Amansa Capital
