Is there a bubble in emerging markets?

Last Updated: Fri, Oct 08, 2010 04:40 hrs

Most market participants are currently scratching their heads, trying to figure out the answer to the above question. Are we setting ourselves up for another big bust, similar to the one in 2008-09? Should investors take their profits and bolt for an exit? But first the evidence, and the reason why investors are concerned.

Wealthy Asians like risk, but picky on assets

In terms of fund flows, dedicated emerging market (EM) equity funds reported strong inflows worth $4.3 billion for the week ended September 29, taking flows for the month of September to $13.2 billion (source: EPFR global); both weekly and monthly numbers are at the highest levels for the year.

Dedicated EM equity funds reported positive flows for the 18th consecutive week, matching the recent record set from November 9, 2005 to March 2006. Since January 2009, dedicated EM equity flows have been over $130 billion, while developed market equity funds have reported outflows of $70.5 billion.

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The $130-billion inflow over the last 21 months is significantly greater than the total net inflows into the EM asset class from inception till 2009. Besides the quantum of flows, the composition is also worrying, since about 61 per cent of the flows year to date have been in the nature of exchange-traded funds (ETFs).

ETFs either signify retail money, which is getting into these developing countries for the first time and is liable to get spooked easily, or they may be the vehicle of choice for large macro funds implementing an asset allocation shift from dollar and OECD [Organisation for Economic Cooperation and Development equity assets. Either of these investors can get out of these markets as easily as they are piling in today.

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In fact, the main attraction of ETFs is the daily liquidity they offer. Conventional wisdom has it that more sticky, longer-term money will not use ETFs, but come into funds directly. There remains the feeling that money routed through ETFs is more transient or "hot money".

MSCI EM total return index relative to the MSCI World index is back to a new high at 150, after dropping to below 90 in October 2008 (December 2006 is taken as 100 for both indices to show relative performance). Such an outperformance will normally revert back to the mean.

Trading volume in EM stocks has exploded, with trading volumes up almost fourfold from the lows of the end -2008 (source: BCA research). Extreme trading volumes normally indicate excessive speculation.

In terms of sentiment, Morgan Stanley recently held a macro conference in which 62 per cent of the clients present were most bullish about EM equities over the next 12 months. In Morgan Stanley's monthly buy-side survey, 86 per cent of its clients were bullish about EM equities, the highest reading ever for any asset class. This extent of bullishness is normally a classic contrarian indicator.

Also, puts on the Asian/EM markets are currently the cheapest and most efficient hedges in the world. The December 2010 95 per cent puts on the KOSPI (cost of 1.5 per cent) are 50 per cent cheaper than buying protection on the developed market indices, for example. This is unusual, as historically EMs have been perceived to be more volatile, with much higher hedging costs.

Though the above signs do indicate a need for caution, with a strong possibility of an interim correction, it seems premature to call EM equities a bubble. It could be a strong upward momentum or an overbought but not a bubble.

Though we have seen huge inflows into EM equities, a majority of the large, long-term pools of capital in the west, especially the US, are very underweight on EMs. An allocation of 4 per cent to EMs is considered to be high among this circle, and given the weight of the EMs in the global GDP or market capitalisation, one can see the scope for this to rise significantly over time.

Most of these institutions also continue to carry an implicit 8 per cent required rate of return on assets to make ends meet. With bond yields globally at multi-year lows, and given the low inflation, low growth outlook in most of the west, these institutions will have to turn to EMs. Thus, though everyone gets it and talks about emerging markets and their decoupled growth prospects, asset allocations tend to move far slower.

We are not any closer to being finished in terms of the movement of assets or allocations towards EM equities. We still seem to be in the initial stages of this structural shift. It is, therefore, not true that everyone has already fully invested in EM equities; there is a buyer at the margin.

In term of valuations also, EM equities are not really trading on any sort of significant premium to their developed market counterparts, trading at about 11.5 times earnings and 15 times even after normalising returns on equity ROEs (to long- term average). Before this cycle ends, I would expect most of the larger EMs to be trading at very significant premiums to the developed markets.

The recent drivers of the surge in risk appetite, viz. the likelihood of the commencement of QE2 in the US and similar moves in Japan, are only fuelling the surge in liquidity out of these markets. The current sweet spot that the EMs find themselves in, the one of very easy global liquidity and differentiated economic growth prospects, is unlikely to change anytime soon. EM equities seem to be far more sensitive to financial conditions in the US and the European Union than real economic performance in these geographies, and till such time as financial conditions tighten, EM will continue to perform.

There remains the chance of a 10-15 per cent correction at any time, but one still gets the sense that this decline would be short and temporary.

Markets not yet at worrying levels

As for India, the markets are acting on cue. India remains among the highest beta markets, hugely geared to easy liquidity, as it needs capital flows both from an external financing perspective and on domestic liquidity considerations. Portfolio flows into India on the margin are important to sustain growth, liquidity and sentiment.

Though the Indian market does seem a little stretched, it is not yet seeing the type of extreme enthusiasm (atleast locally) as seen in the end-2007. The majority of professional money managers in India remain quite cautious, with reasonable cash on the sidelines. Raising money for India is still not that easy, and though huge IPO issuance has begun, crazy excesses in this space are still some time away.

The only wrinkle on the horizon is the momentum building in commodity prices, which can harm the attractiveness of the India story. Investors should be balanced and not lose their head since it is in times like these that the worst mistakes are made. Don't chase the markets, but remember this is not December 2007 either.

Many people are of the view that this whole cycle will eventually end with a big bubble in the EM equity asset class. I also subscribe to this view, since all the conditions for a bubble to develop are in place - easy liquidity, an economic displacement as the major EM countries decouple economically with the west and huge profits made by early converts to the idea. This bubble will come, it just isn't there yet.

The author is the fund manager and chief executive officer of Amansa Capital

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