Emerging Boom or Bubble?
14 February 2007
Business Times Singapore
Foreign capital continues to flow at near record levels into Asian and other emerging stock and bond markets. Is it a boom based on the healthy growth of these economies - or is it a liquidity-driven bubble that is destined to burst eventually, creating distress that could make the 1997 financial crises in Asia and other regions appear mild by comparison?
The Business Times invited experts from different backgrounds and with differing views of emerging market prospects to comment after the Institute of International Finance (IIF) in Washington warned that investors who appear to be taking a fairy-tale view of continuing global economic stability could be in need of a wake-up call.
Total capital flows into stocks and bonds, plus bank loans and business investment in 30 emerging markets around the world reached nearly US$502 billion last year, only slightly below the record US$509 billion in 2005, and will stay high this year, said the IIF.
Portfolio equity flows to emerging markets have more than doubled over the past 10 years. They reached over US$70 billion last year (of which Asia accounted for some US$40 billion) and are expected to moderate only slightly to US$63 billion this year.
Investment in emerging bond markets is meanwhile running at over US$100 billion a year (of which Asian emerging markets receive roughly one third) and will also continue at high levels.
Surging capital flows reflect abundant global financial liquidity, and this pool could shrink as central banks in Europe and Japan continue to tighten monetary conditions, said the IIF. There are other risks to emerging markets, such as increasing geo-political tensions with potential effects on the real economy and on market sentiment and risk appetite; uncertainties about the duration and severity of the ongoing housing slump in the US, and the ever-present potential of huge global current account imbalances igniting a disorderly adjustment.
The emerging market boom is being driven not just by the usual groups of yield-hungry institutional investors such as pension funds, insurance companies and mutual funds but also by hedge funds acting on behalf of central banks from Asia and elsewhere that are diversifying foreign exchange reserves 'covertly' out of US Treasury securities into stocks and bonds, one of our experts suggested. China has also become a major factor in emerging market investment, he suggested.
The consensus was that the party will go on until it ends - because few are eager to leave before then.
PARTICIPANTS in the roundtable
Moderator: Anthony Rowley, BT Tokyo correspondent
Mark Mobius, president of Templeton Emerging Market Funds and a globally recognised authority on emerging markets
Ernest Kepper, former senior World Bank and International Finance Corporation official and Wall Street investment banker who now heads an Asian financial consultancy
William Thomson, chairman of Private Capital Ltd, Hong Kong and senior adviser to Franklin Templeton Institutional Hong Kong and Axiom Opportunities Fund, London
Anthony Rowley: The IIF says that investors in emerging markets are pricing assets 'as if the Goldilocks global environment will continue undisturbed' into the indefinite future. This is strong stuff coming from an organisation that speaks for many of the world's leading financial institutions. Does it mean we looking at an emerging market bubble?
Mark Mobius: Our friends at the IIF have generally focused on bond markets and it is easy to conclude that the current spread of emerging markets debt instruments versus US Treasuries seems to have gone too far when one first looks at how that spread has come from over 1,000 basis points (over 10 per cent) to less than 200 basis points.
Also, anyone who remembers the Argentina debt default and other defaults in places like Russia must think that bond investors are out of their mind to be purchasing emerging market bonds which are paying less than 2 per cent above US Treasury bonds.
But conditions have changed and the macroeconomic environment and conditions in emerging markets have strengthened dramatically since the Asian crisis period in 1997. Looking at the numbers, it is reasonable to assume that emerging market bond prices should be substantially lower than they were during those crisis times.
Turning to equities, although share prices have increased strongly in recent years, so have (company) earnings. This means that although price/earnings ratios and price to book value ratios have risen, they do remain reasonable.
Of course, no one can predict the market direction and a bear market could start at any time. However, the good news is that bear markets are shorter in duration than bull markets and bear markets go down a smaller percentage than bull market increases. Global economic conditions are positive and countries have made substantial strides in reforming their economies.
Moreover, emerging markets continue to report strong macroeconomic growth and are implementing structural reforms. Taking a long-term view, emerging markets continue to offer investors an attractive investment destination. The role of emerging markets in the global economy has grown significantly in recent years. These countries have made fundamental improvements to their economies and the changes are here to stay. These developments mean that emerging markets investments contain good opportunities.
William Thomson: I believe the IIF has hit it pretty well on the head this time. Globally, assets are priced to perfection: investors are overwhelmed by complacency and the concept of risk has been comprehensively, but temporarily, junked. There are different ways of measuring complacency but most of them involve the willingness of investors to absorb ludicrous amounts of debt.
We see that in the case of individuals in the Anglo Saxon property markets, especially the UK, now that the US is correcting, where people are taking on mortgages that can only be paid over generations, a situation reminiscent of Japan in the late 1980s.
Personal debt levels are unsustainable levels in the advent of any disruption to personal circumstances. Similarly, in the corporate level we see private equity investors assuming greater and greater levels of debt of riskier assets.
The potential shocks that could upset the applecart include a changing of the acceptance of the present pace of globalisation in the developed world where middle and working class standards of living are stagnating at best. US average wages are lower now in real terms than they were 35 years ago whilst the returns to capital are now above the 7-15 percent GDP range where they have always been contained for over 100 years, and politicians are likely to be increasingly susceptible to calls to amend the terms of trade in coming years. Geo-political factors, especially a deterioration of the Iran/Iraq situation in the Middle East, remain a key potential flashpoint that could roil the markets.'
Anthony: The Emerging Markets Bond Index (EMBI) spread reached an all-time low of 170 basis points in December last year while the Morgan Stanley Capital International (MSCI) equity index hit a record high at the end of the year. What has driven these up to such heights, and can they be sustained?
Ernest: The main reason for the increase in the flow of funds to the equity markets of emerging economies is that many central banks have made an unofficial or unannounced decision to shift their investment from US Treasuries. This has led to a shift to euro bonds and secondly to American and European corporate securities. But because those markets have natural limits, the real returns are being gained in emerging markets. This is not a matter of any change in the basic matrix of the economy or the financial system in any developing country; it is merely an excess of liquidity grown out of the willingness or the decision of the central bankers of most countries to reduce their investment in US Treasuries.
These flows are hard to trace because central bankers are often reticent about going direct into the market and it is big money, so they will put large amounts of money with a hedge fund or with what we call the 'deep hole' investors.
More and more trades are moving off the NYSE because big investment banks can avoid fees by matching buyers and sellers.
Also, many funds do not want to have a record or open disclosure of where they are investing money or when they are withdrawing it. By using a bank or brokerage houses and getting an internal match, transactions do not have to be reported.
Money can be invested without, say, Japan having to record the fact that they are investing in the Indonesian stock exchange.
(The emerging market boom) is also being driven by liquidity generated in China. I understand that even the social security funds and pension funds and the government funds of China are committing billions of dollars to hedge funds and investing in emerging markets because of the desire to gain double-digit returns. China has attracted almost a billion dollars a week since it joined the World Trade Organisation. This is very welcome because it fuels the new issues market in China which is very strong and growing with global investment banks competing to see to who can get the most IPOs (initial public offerings).
There is excess liquidity and China is taking advantage of it. One of their major banks just raised over US$50 billion. That money cannot be invested immediately in China and so it will need to be channelled into other short-term investments.
So, we have this great liquidity developed by central banks shifting away from US Treasuries and we have the excess liquidity of China which has raised hundreds of billions in the past five years in IPOs. All this money has to be placed somewhere and nothing compares to the possibility of injecting it into a developing country. In cases like Argentina, which has given Europeans and Americans a 70 per cent haircut on over US$100 billion of debt, we see no reticence on the part of banks and investors to come back into the Argentine economy to buy stocks, participate in IPOs and even enter the bond market.
Mark: Strong investor confidence, continuing fund inflows, robust corporate earnings, favourable financing conditions, stock market appreciation and a cultivating macroeconomic environment with strong economic growth are among the key factors that have contributed to low spreads.
While I do not believe that we are seeing a 'bubble', as I mentioned before, no one can predict the market direction and a bear market could start at any time. However, the good news is that bear markets are shorter in duration than bull markets and bear markets go down a smaller percentage than bull market increases.
William: Long term, I am a bull on emerging markets and believe institutional investors should generally be overweight them to capture their higher underlying growth rates. However, after the bull run of recent years, this is a time for greater caution and selectivity for the reasons given previously. I would expect far greater volatility than in the recent past and that argues for a long/short approach.
Anthony: Do you agree with the IIF that the apparent lack of concern by many investors about the implications of a possible adverse turn in the world macroeconomic outlook points to vulnerability and that 'more prudent market risk management is essential'?
Mark: In the imperfect world that we live in, there will always be investors who are hoping to make a quick profit with little regard to stock fundamentals. And yes, of course it would be great if everyone practised more prudent risk management but then that could lead to lower market liquidity and volatility. For the value investor, volatility is a good thing since it gives an opportunity to purchase stocks at below their intrinsic value and sell above their intrinsic value.
William: Again, I fully concur. Let us look at what is going on in the derivatives markets. Global GDP is about US$50 trillion and according to the BIS total derivatives have expanded from US$200 to US$400 trillion a couple of years ago: that is eight times world GDP. A decade ago that would probably have been less than one times GDP.
No one can possibly know what is in all those black boxes but we are likely to find out one day that they are in Warren Buffett's terminology weapons of wealth destruction. In the meantime, the 30-something wunderkinder who put them together will be viewing the destruction they have created from their villas in the South of France paid for with their multimillion dollar bonuses.
Anthony: Do you expect IPO activity in emerging markets to continue at high levels in 2007?
Mark: Yes, we do expect IPO activity to remain strong. This is because equity prices have risen and company controllers find it attractive to list their stocks. In addition, emerging markets remain an attractive investment destination and IPOs allow investors to gain exposure to companies in these markets. Moreover, the cultivating macroeconomic environment has led to higher earnings leading many companies to expand their operations and raise funds. Obvious markets include China and Russia.
William: I would look for continued strong activity from Asia until or unless there is a sharp correction. Prices are attractive for issuers.
Anthony: Will the seemingly ever-expanding supply of new portfolio assets from emerging markets force a price correction, especially at a time when global liquidity could be squeezed by monetary tightening in Europe, Japan and, possibly, the US?
Mark: There is always that possibility. We have now seen a massive flow of liquidity into emerging markets and this has pushed prices up. As mentioned, the healthy earnings of emerging market companies has made the price rises sustainable. However, any reversal of the money flow or a reversal of company earnings could present problems and a market correction or even a bear market.
William: Prices can correct at any time when fear begins to override greed.
Anthony: So, when does the party stop?
Ernest: Nobody can stop it. A central bank which has a surplus from exports to the United States simply has to invest the money. The game is to get the money invested quickly and to go for double digit returns. The biggest players in the game are hedge funds because they are not on the same regulatory reporting basis as mutual funds and they are much larger.
If they are producing double-digit returns, it cannot be from investing in corporate bonds or US Treasuries. It cannot be by investing solely in real estate so it must largely be in emerging markets. As long as there is excess liquidity - as long as there are no major bankruptcies in countries or among major corporates there is no reason to draw out large amounts of equity.
The only other possibility is that a major hedge fund gets embroiled in some derivative activity which could become unwound and scare the market and cause people to withdraw. Or, it could be that more merging markets will follow the example of Thailand, or Malaysia at the time of the 1997 financial crisis, and impose controls on short-term capital movements.
Emerging markets have 'strengthened dramatically' since the Asian crisis of 1997
The concept of risk (in emerging markets) has been comprehensively junked
Central banks have become significant players in the emerging markets boom, using hedge funds as a front Emerging market investors are assuming that the 'Goldilocks' environment can continue undisturbed.