Interpreting Middle East Economic News and Analyzing Market Trends

Is the emerging markets party over?

Chart foriShares MSCI Emerging Markets Index (EEM)

Source: Yahoo Finance EEM: iShares MSCI Emerging Markets  –  PEMPX: Pimco Emerging Markets Bonds  –  PNMA: PowerShares MENA Frontier Countries

  

Since the Financial Crisis of 2008, emerging markets have been pushed and promoted as the world’s new growth engine.  As bond yields in developed markets dropped closer and closer to zero, institutional investors circled the globe in search of higher yields.  Fresh billions flowed into emerging markets, which lead to a dramatic drop in bond yields as investors piled in (see our earlier posts here and here) making it cheaper and cheaper for these markets to borrow.  So they borrowed, borrowed and borrowed some more.  Now it appears that emerging markets have lost steam.  From the chart above you can see that both emerging market bonds and stocks underperformed the S&P 500 over the past two years.

 

A record amount of money poured out of exchange-traded and mutual bond funds in June, according to a fresh report by TrimTabs, nearly double the amount pulled out of bond funds at the height of the financial crisis in October 2008.

Investor fears over the scaling back of the U.S. Federal Reserve’s bond purchasing program has seen the yield on 10-year Treasurys rise sharply to 2.5 percent as $80 billion left bond funds in June, according to the research.

The herd is scrambling for the exit this month as bond yields back up across the board and central bankers hint that they might provide less monetary stimulus in the future,” TrimTabs CEO David Santschi said in a research note on Sunday. “We estimate that bond mutual funds have lost $70.8 billion in June through Thursday, June 27, while bond exchange-traded funds have lost $9.0 billion.”

The rush out of bonds could be about to get even worse, according to the research firm, which says that more bond investors could take flight after receiving their quarterly statements in the coming weeks, noticing that their “safe” bond funds are delivering losses instead of gains.

The global sell-off in bonds began on May 22, after the minutes of the Fed’s policy meeting signaled that its bond-buying program—which has suppressed yields and boosted stocks—could soon be pared back. Fed Chairman Ben Bernanke echoed that view at a press meeting last Wednesday, suggesting that asset purchases could be scaled back later this year if economic data continued to show improvement.

TrimTabs call the liquidation “unprecedented” after indicating last Monday that bond outflows had already reached records with a figure of $47.2 billion. In just one extra week that number has risen to $79.8 billion which it says is reversing 73 percent of the $109.6 billion inflows seen

“Until last month, investors had been content to shovel huge sums into bonds with little regard for value, confident that endless central bank liquidity would keep prices at ridiculous levels. It was only a few weeks ago that junk bond yields dipped below 5 percent for the first time.”

Erik Nielsen, chief global economist at UniCredit told CNBC that the interest rate on a benchmark 10-year Treasurys will move even higher after stabilizing at the 2.5 percent level as bond investors continue to drag money out of funds.

“There’s a lot of liquidity, the world is slowly getting better and people are sort of finding the normal level of risk again….in the process of going to 3 [percent bond yields] they will leave,” he told CNBC Monday.

Nielsen called this a “critical” period for the bond markets, with the world’s pension funds and insurance companies loaded up with “safe haven” government treasuries that are now facing capital losses after receiving negative real yields for three or four years.

Read the full story from CNBC.

 

If this trend continues, emerging markets will face a severe credit crunch followed by defaults.  Yields on emerging market bonds will return to a normal level, but this means trouble for many issuers, both sovereign and corporate, as they struggle to keep up with the rising yield.  Had yields stayed at a normal level (i.e. without the Fed and ECB artificially forcing rates down) emerging markets would not have been able to get cheap money in the first place.

 

A test for GCC markets is coming up.  Saudi Arabia’s Algosaibi is planning a $7.2 billion debt issue.  This comes after Algosaibi became the largest Middle East corporate to default during the financial crisis.  If successful, it could mean that emerging market debt still has a little stream left.  However, the Saudi market is a different animal since it has a lot of local liquidity and is not foreign investor dependent.

 

One thing is for sure, emerging markets are in a bubble and all bubbles pop.  The record amount of emerging market debt issued means that the bubble pop will be extra special.