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Sell Emerging Markets in May, and Maybe June and July Too

Monday, 3 Jun 2013 | 4:53 AM ET
Sha Ying | CNBC

Sell in May? They certainly did in emerging markets. But unlike in the old adage, they are likely to sell in June and July too if investment returns in the once-hot sector keep getting slammed by moves in U.S. bond yields and the dollar.

Emerging currencies have crashed to multi-month and even multi-year lows against the dollar in the recent frantic selloff, with emerging bond funds suffering their first weekly outflow in a year, according to data from EPFR Global.

The Boston-based fund tracker reports redemptions of $224 million from emerging debt in the week to May 29, while equities lost $2.9 billion, their biggest outflow since end-2011.

"People are really worried we will see a 1994-type market event, when the Fed hiked rates and emerging markets suffered a lot," said Pierre-Yves Bareau, head of emerging debt at JPMorgan Asset Management in London.

Memories of 1994 have been stirred by recent talk that signs of a U.S. economic recovery could induce the Federal Reserve to scale back its money-printing, risking a repeat of the market bloodbath that followed Alan Greenspan's decision to start tightening policy almost 20 years ago.

As years of rock-bottom U.S. yields draw to a close, emerging markets, at least temporarily, may be victims of the Fed's success in pulling the U.S. economy out of its funk.

During these years they have enjoyed an investment bonanza. EPFR data shows over $46 billion flowing to emerging stock and bond funds since January, after almost $90 billion last year.

But 10-year U.S. Treasury yields, considered the risk-free benchmark for most assets, rose 40 basis points in May while the greenback surged.

And while some weak U.S. economic data has dampened expectations the Fed will end, or taper, money-printing early, the emerging markets selloff shows no sign of abating.

(Read More: Is Another Turbulent Month in Store for Markets?)

"The seed of doubt has been sown as to what prospects the emerging markets trade has from here," said Manik Narain, a strategist at UBS. "The big picture is: the U.S. economy is recovering and the Fed has signalled that tapering will happen."

Put simply, an investor comparing 10-year U.S. yields at 2.2 percent with the 5.2 percent offered by, say, Chile, might well, given the skew of currency risk, opt for the former.

That is partly because real interest rates - taking into account inflation - in most emerging markets are negative and have fallen below U.S. real rates, says Narain at UBS.

Many also fear this round of U.S. recovery, possibly fuelled by re-industrialisation rather than relying on emerging market imports, may not be bullish for the developing world.

The boom in recent years has meanwhile slashed yields on emerging debt. JPMorgan's main GBI-EM index yielded a record low 5.2 percent in early May, 120 bps less than a year earlier.

What They Sold in May

The panic over U.S. rates blew emerging dollar bond spreads almost 20 bps wider over Treasuries in May to bring 2013 returns to minus 3 percent. Local debt yields meanwhile rose 50 bps, with returns tipping into the red in the past week.

Emerging equities slumped more than 3 percent, their biggest monthly loss in a year, while currencies, which typically make up a significant portion of investors' annual return, have also slipped.

According to UBS, an equally weighted basket of 20 emerging market currencies that it tracks has lost 3.7 percent to the dollar this year, the bulk of the weakening coming in May.

These may seem like big moves. But while negative return is a powerful sell signal for funds, most big investors are still hanging in there, with losses so far down to so-called hot money exiting or a pickup in currency hedging, analysts say.

(Read More: Fed, Bond Market Tango to Get Hotter)

Foreign investors are estimated to hold a third of emerging local debt and more in countries such as Peru and Hungary.

That is why Benoit Anne, head of emerging markets strategy at Societe Generale, is advising clients to close long emerging debt positions before the real selloff gets going.

"We have seen some selling, but nothing that looks like capitulation yet. When and if this kicks off, it will fuel another massive wave of correction," Anne says.

He does not believe the coming storm will spare emerging economies with stronger finances and policies.

"We have moved on. Forget about the bottom-up ... The Fed matters more in Israel than the Bank of Israel."

Overshoot?

Not everyone agrees, of course.

"It should be good news for equity investors that the Fed is talking of tapering," says Bill Maldonado, Asia-Pacific CIO at HSBC Global Asset Management. "Everyone is worried about bond yields rising but it also means we have an economic recovery underway."

But in 'deficit' economies such as South Africa, Turkey and India, which have big external funding needs and have been at the forefront of the May selloff, the rout could extend further.

(Read More: Warning: 'Prepare' for Commodity Supercycle End)

South Africa's rand is at four-year lows while bond yields have jumped a whole percentage point in May.

"South Africa is probably close to a point where you could look at it," said Bareau, who thinks the wider selloff overdone. "There is a sense of a falling knife and you don't want to catch it until it is actually on the floor."

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