World Economy

Investors Rotating Out of Emerging Market Equities

Investors Rotating Out of Emerging Market EquitiesInvestors Rotating Out of Emerging Market Equities

The recent move by China’s central bank to weaken its currency and the likely US rate hike has cast a huge shadow over the asset class.

Emerging market currencies and the relative performance of equities are correlated and any movement in those currencies broadly explains roughly 40% of the stock market performance, according to a recent note by Axa Investment Managers, International Adviser reported.

“The coming US interest rate hike can hardly be considered a good omen given the indebtedness of many emerging economies. “Further EM currency weakness will lead to further stock market weakness... It is not the time to be brave.”

Investors are generally worried that the US rate hike could lead to outflows from EMs and pressure EM corporates that have US dollar-denominated debt and local currency revenues.

Following the recent US Federal Reserve meeting, the chances of a rate hike in September looks less likely. But even if interest rates are left unchanged next month, EM equities and currencies still face mounting pressure.

“Beyond China, emerging market stocks and currencies are trading down to multi-year lows. Even with a declining likelihood of an imminent Fed hike, investors continue to rotate out of the asset class,” said Russ Koesterich, chief investment strategist at BlackRock in a recent market note.

 Strong Headwinds

Emerging markets have lagged developed market performance since late 2010 in both US dollar and local currency terms. The MSCI Emerging Markets Index has been flat over the past five years while the MSCI World Index returned roughly 70%.

Given the slowdown in China, the key driver of the region, the overall economic growth momentum in EMs is expected to remain weak and weigh on corporate sector earnings in the coming months. Industrial production has been declining and Axa IM believes the consensus earnings growth projection of around 10% for the coming twelve months looks “overly optimistic”.

 “Worse, profit margins have gone from weak to weaker over the past couple of years while corporate leverage has increased. We would not be surprised to see analysts’ earnings growth forecasts of almost 10% to be trimmed in the coming weeks.”

 Flight From ETFs

China’s slowdown and the commodities slump has resulted in outflows from equity and fixed income ETFs at the fastest pace in the last 18 months, according to Markit.

So far during the July-September quarter, investors have pulled over $3.7 billion out of the 229 emerging market and BRICS-exposed ETFs. “While investors have been largely avoiding emerging markets in the last 12 months, the outflows seen so far this quarter are on track to mark the worst quarter for the asset class since Q4 2014,” Markit said.

 Who Will Lose?

The extended rout in emerging markets raises a question: Who stands to bear the most losses? Judging from the available data on cross-border exposures, it’s worth keeping an eye on banks in Spain, the UK and Taiwan.

China’s decision earlier this month to devalue the yuan has accelerated declines in the stocks and currencies of countries ranging from Russia to Colombia. The selloff in part reflects concerns about the ability of developing-nation companies and governments to bear their foreign debts, which have grown rapidly in recent years.

Consider, for example, the cross-border exposures–including loans and derivatives–of global banks to countries that have experienced significant currency depreciation over the past month. As of March, they stood at more than $4 trillion, according to the Bank for International Settlements.

If loans start going bad and losses mount, will there be another financial crisis? It’s hard to know. If the losses are spread widely among investors who can afford to take a hit, no problem. If they’re concentrated in large, thinly capitalized banks, that’s more troubling.

While investors have been largely avoiding emerging markets in the last 12 months, the outflows seen so far this quarter are on track.