Emerging markets are the share (and bond) markets of emerging economies (such as Indonesia and Brazil) as distinct from the more mature developed economies (such as US and Germany). They have historically benefited from being within countries with higher levels of economic growth, but have also experienced more volatility than developed markets. In recent weeks emerging markets have started to make the headlines (again), as their share markets and currencies have increased in volatility.

Most commentators seeking to explain why emerging markets have become more volatile have focused on the argument that the key cause of this instability comes from the US central bank (the Federal Reserve or “Fed”) scaling back its Quantitative Easing (QE) program. QE is effectively where the central bank tries to stimulate the economy by driving down interest rates by intervening in bond markets. With interest rates being forced down in the developed world investors, in a “reach for yield”, resorted to buying higher yielding emerging market securities. It is argued that now, with the Fed starting to tighten monetary policy and interest rates starting to rise, there has been an outflow of this “hot money” from emerging markets; causing emerging market share markets and currencies to fall in value.

Is this a reasonable and complete explanation of what is going on in emerging markets?


Direct linkages between QE and EM

We can differentiate between two kinds of linkages.

Firstly we have direct causal linkages. This is where an action, like reduction in QE, directly leads to an outcome: a withdrawal of liquidity from Emerging Markets (EM). Secondly linkages can be indirect. Here the action (change in QE) leads to a change in investor perception; and this in turn leads to behavioural changes with investors choosing to sell their EM investments. In this second instance the linkage is via investor psychology more than anything else.

This distinction may sound a little academic, after all whether direct or indirect aren’t the outcomes exactly the same?

Well yes, they are initially, but there may be material differences in the subsequent behaviour of EM investors depending upon whether this linkage is fundamental and direct, or psychological and indirect.

If for example we think that a reduction in QE is here to stay (which is likely) and the linkage is direct then one would expect ongoing weakness in EM.

If indirect, then subsequent investor behaviour may be quite different. Psychology can be very fickle, what’s out of favour today may be in favour (or just ignored) tomorrow.

In our view the case for a strong direct linkage between EM and the end of QE is at best only a partial explanation for what’s going on.

This is largely because an examination of capital flows into EM illustrates that much of the flows are of a longer term nature, being direct foreign equity investment (and associated lending) in a business located in an EM country. This is in contrast to the less sticky and short term investing that has been made as part of an asset allocation decision in constructing a global diversified portfolio. “Hot” money has certainly flowed into EM, and has recently started to leave these markets. But we believe much of the inflows into EM are of a longer term nature.

The tables below give a breakdown of capital flows into the Asia and Latin American EM economies:

Source: The Institute of International Finance

There is clearly some capacity for a reversal of flows, particularly from the category of inflows termed “Private Creditors-Non banks” which we suspect includes shorter term capital chasing higher yield investments that is probably very short term in nature. However, the data above indicates most inflows to EM economies have been in the form of Foreign Direct Investment (FDI) which is quite illiquid (e.g. building a factory) and not easy to reverse.


An alternative explanation for EM weakness

We believe that what are experiencing in EM today is not going to be confined to EM.

Rather, we fear we are experiencing the early stages of what will end up being a much more widely based rise in global risk aversion. If this explanation is correct then the current EM volatility is more akin to the proverbial “canary in a coal mine” than the proximate cause of the problem.

If we are correct in this assessment then we would expect to see the weakness currently being experienced in EM markets start to manifest itself in growing concerns and weakness in a much broader range of developed economy markets.

So the good news is that the recent volatility in EM is more due to their initial sensitivity to risk aversion, that a more fundamentally based case against EM investments. The bad news is of course that if we are

correct there is likely to be a sharp increase in volatility in a much wider range of markets in the not too distant future.

We see evidence of increasing levels of risk aversion in a growing number of indicators for DM particularly US equities as can be shown in the charts below.

The first chart shows the “skew” in US equity options markets via the Skew Index. This index indicates the degree to which out of the money put options are more expensive than other options. In other words, it tells you how much investors are willing to pay up for buying protection against a significant sell-off. A reading of 100 indicates a neutral position; the current elevated levels of the index indicate market participants are aggressively bidding up the price of downside protection.

Source: Pragcap.com

The second chart shows the ratio of insider sells to buys in the US equity market. Insiders (corporate senior management) are selling their own shares at a very aggressive pace.

Source: Pragcap.com



We think the weakness in EM is possibly a precursor to something more serious, not a specific issue for this sector.

Furthermore, we suspect that the current negative investor psychology that is hostile to EM may prove to be fairly transitory and subsumed by greater concerns in the coming months.

EM equities look to us to be an asset class in which much of the bad news is already “in the price” they are trading at “cheap” valuations as can be seen in the chart below:

Many developed market share markets by contrast look quite expensive, and frothy.

As an additional layer of protection we prefer to buy our EM exposure via a specialist investment mandate that focuses on buying listed infrastructure companies in emerging markets. These are more defensive than other classes of EM equities.

Sometimes making good investing decisions requires one to both go against the trend and buy the out of favour sectors at attractive valuations rather than stay with the more expensive and in favour sectors that look “safe”. This is how we see EM investments today.


Justin McLaughlin, Chief Investment Officer

Hamish Bell, Senior Research Analyst


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