Emerging markets assets have had a rough go of it for several weeks now as U.S. Treasury bond yields have shot higher, but the past week especially was not kind to funds invested in EM.
In the week ended June 19, EM funds recorded a massive $2.6 billion in outflows, or 1.0% of assets under management.
That marks an acceleration of outflows from the previous week, when investors redeemed $2.5 billion from EM funds.
The big question is whether this is the start of a big blow-up in EM debt markets, which have seen massive inflows over the past several years as depressed bond yields in developed markets have sent investment capital into riskier credits in the emerging world in search of higher yields.
Deutsche Bank macro strategist Alan Ruskin reflects on this in a note to clients this morning:
The post-2008 cumulative $1 trillion+ private portfolio flows from the developed world to the EM world have a decision to make: Can they ride out the Fed’s very slow, well mapped out retreat from the easy money policies that have encouraged extreme yielding seeking? For those who wait, the additional yield accrued by waiting for any exit has the potential to be modest relative to the potential capital lost, unless there is a belief that the asset itself is already cheap relative to long-term value. Unfortunately, in a number of cases (the BRL would be a good example) even the long-term value is being reassessed lower, because independent of the Fed, growth in almost all major EMG countries has looked weak.
The Fed has only shaken half of the tree, because in the initial instance, developed private capital may exit EM assets, but EM central banks are loath to sell their reserves and exit developed markets. Initially, only one half of this major cumulative capital flow between developed country assets in the developing world, and, developing country reserves held in developed currencies unwinds. EM exchange rate then take the brunt of the adjustment, until EM central banks say enough is enough. So far EM central banks are only moderately smoothing exchange rate adjustments. When and if central banks become more active this may help EM exchange rates, but the price will presumably be paid in developed country assets notably the developed world fixed income instruments that developing central banks like. The private sector capital retreating from the EM world back to the developed world will likely have a very different risk propensity to the more passive investing style of central banks. Anything that roils developed bond markets will in turn surely feed back negatively on the appetite for EM assets.
This is one example where even in a world with considerable Fed guidance policy certainty can set in train forces that are hugely destabilizing, if they are perceived as a fundamental reversal of what has preceded it. The drawing out of the Fed exit plan by extending QE tapering could in theory smooth the above adjustment, but just as likely it will bring much of the adjustment forward, before creating additional volatility as the market tries to assess when developing market assets are genuinely cheap.
The chart below from Morgan Stanley shows the damage from fund outflows this week.
Morgan Stanley Research, EPFR
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