Liquidity See Saw in Emerging Market Debt Funds
According to Ashmore Asset Management, a London-based specialist EM debt fund manager, the amount of tradable emerging market debt rose from US$2.4 trillion in 2000 to US$14.8 trillion in 2014. After a slight hiatus in 2015, that growth continued through 2016 and 2017. EM debt growth has been mirrored by a growth in EM debt funds. In 2017 alone, the fund management industry witnessed US$100 billion of inflows to emerging market bonds. This long-term growth has had a powerful effect on the profile of EM debt markets, both in US dollars and local currency, and the level of international participation.
An additional powerful catalyst to the growth in EM debt funds came from investors’ responses to the Global Financial Crisis (GFC) and the subsequent aggressive monetary policy response.
While South Africa experienced economic pain associated with the GFC, there was never the same level of systemic concerns around its financial system as local banks were reasonably capitalised. This was different internationally, particularly in Europe and the US, where genuine concerns surfaced about the survivability of many mainstream retail banks. Monetary policy response to GFC was aggressive. Interest rates were cut to close to zero around the world and alternative monetary stimulus, mainly Quantitative Easing (QE), was initiated, creating a flood of liquidity into the financial system. With interest rates at record lows, this cash needed to find a home that could generate some form of capital or income growth. Even relatively conservative investors were forced to broaden their horizons in the desperate hunt for yield.
Driven by this hunt for yield, asset classes like European and US High Yield credit benefitted from investor interest but with economies moving into recession, the flow of new credit issuance was relatively low. Emerging markets, on the other hand, rapidly evolved as viable credit markets and had a strong desire for higher issuance in the traditional dollar-denominated space as well as in local currency.
The spotlight quickly fell on emerging market debt as a potential home for capital and in the period following the GFC, flows increased substantially into a broad number of EM debt instruments. Large global asset managers responded rapidly to this opportunity and launched or increased the profile of their EM debt funds. Only ten years ago, EM debt funds were a relatively niche area for specialist fixed income managers; suddenly every global asset manager was active in this space. This inflow dynamic had a positive effect on yield spreads and the market was relatively indiscriminate in terms of individual country risk profiles.
The combination of this liquidity injection and the global economic recovery resulted in strong performance from EM debt assets and underlying investment funds. The good times, however, could not last forever. As interest rates in the US have risen, investors have seen the other side of liquidity flow. Trump-induced trade tensions and a stronger US dollar has resulted in negative liquidity flows and disappointing recent returns. In addition, country-specific risk has reappeared on the investor radar. Turkey, Brazil, Russia, Argentina and Pakistan have all reached a fiscal impasse that is resulting in fairly drastic actions, including some applying to the International Monetary Fund.
After close to 10 years of low interest rates and Quantitative Easing in the Western World, the risk from the liquidity unwind is one of the big issues that all investors face. EM debt funds have been in the teeth of that concern and there remains a high degree of uncertainty about how much of the money invested in this space is structural and long term rather than vulnerable to short-term sentiment.
Over the short- to medium-term, multiple factors that could impact EM flows include unexpectedly higher inflation in the US triggering a stronger-than-anticipated monetary policy response. Meanwhile, it has also become apparent that emerging economics are not being equally impacted by the recent EM crisis and volatility. Those with more vulnerable economies are taking the brunt of volatility including the likes of Brazil, Turkey, Russia, Argentina and South Africa.
From a South African perspective, improved GDP growth will be the panacea to many of the country’s problems. However, on the path to improved growth many smaller signs can positively boost SA’s prospects, such as political stability, policy clarity, business confidence, employment and capital expenditure. These signs are monitored on a monthly basis by STANLIB Chief Economist Kevin Lings and compiled into a Measuring South Africa’s Economic Turnaround Report to help investors navigate the uncertain environment ahead.