Emerging markets are back in vogue. Record inflows of funds have swelled developing country bonds over the past seven weeks, while investment into equities hit a 58-week high this week. This may seem like sweet redemption for an asset class that fell from favour in early 2015, but closer inspection reveals an uncomfortable reality. This is a spillover rally, inspired not by the magnetism of emerging markets’ innate qualities but by a deepening aversion towards monetary policies in the west.
Unprecedented levels of quantitative easing by central banks in the UK, Japan and Europe have depressed interest rates to historic lows. With investors now having to pay for the dubious privilege of owning some $13tn in negative-yielding bonds in developed markets, many are fleeing to the emerging world in search of positive yields. The risk premium, therefore, has become the selling point.
If this contradiction in itself does not give investors pause for thought, then at least three other issues should. The term “emerging markets” - and the alphabet soup of indices that are based on it - defines a deeply flawed concept that implies equivalence between assets as incongruous as Taiwan and South African government bonds and the strength of economies as diverse as India and Russia.
Moreover, it is no longer clear that some parts of the “emerging” world are necessarily riskier than their “developed” counterparts. On a per capita income basis, Qatar, Saudi Arabia and South Korea are wealthier than several developed countries while an analysis of the relative strengths of Chile and Portugal shows the Latin American country to have a bigger economy, bigger population, less debt and lower unemployment than its “developed” European counterpart.
Investors pouring billions of dollars into index-tracking emerging market funds should be clear that they are buying a jumble of assets that defy risk management. The emerging market classification is also victim to the curse of skewed averages; China is so large a presence in almost every aggregate metric that it distorts any measurement of the asset class.
Debt is a case in point. China’s corporate debt level to gross domestic product was 171 per cent in 2015, according to a recent study by Standard & Poor’s, the credit rating agency. This was not only more than double the ratio for the US and the eurozone, it was also off the charts when compared with most emerging countries. Thus, although it looks on average as if emerging markets are staggering under a crushing corporate debt burden, countries such as Indonesia, Brazil, Mexico and India have among the lightest company debt loads in the world.
This is not to suggest that China’s influence is unimportant. Any investor who buys funds that track the MSCI EM stock index, an influential benchmark, is taking on a hefty exposure to China, which has a 26 per cent weighting. This may perturb some as the world’s second-largest economy struggles to generate a viable return from its debt binge of the past eight years. Whereas before the global financial crisis in 2008, China needed just $1 of credit to deliver $1 of GDP, the ratio is now six to one, says Morgan Stanley.
Beyond China and the flawed emerging markets classification, investors should ask themselves how durable the liquidity migration from developed markets really is. If the US Federal Reserve starts to raise interest rates, the differential between US and emerging market yields may begin to narrow, undermining the main rationale behind the spillover rally.
