Tuesday, May 30, 2006

Turmoil is test for investors’ staying power

Turmoil is test for investors’ staying power
By Jennifer Hughes in New York
Published: May 30 2006 05:01 | Last updated: May 30 2006 05:01. Copyright by The Financial Times

Is it over yet? That is what investors in developing markets are asking as they emerge from the storms of the past fortnight that have left many bruised and battered.

The MSCI emerging markets equities index has fallen 13 per cent in two weeks while currencies have swung wildly and bonds tumbled.

Investors searching for higher profits have poured funds into developing economies in recent years. What observers are now debating is if investors will stay and weather the latest turbulence or turn tail and head for the safety of their home markets, leaving emerging economies reeling.

The trigger for the recent rollercoaster was concern about overheated commodity markets following a spectacular run-up – similar to that seen in many emerging economies. It then widened as markets worried that rising inflation would push global interest rates higher than previously expected, draining even more liquidity from the financial system.

”When you’re talking about tightening liquidity, emerging markets do tend to suffer,” said Brad Durham, a managing director at Emerging Portfolio Fund Research, a fund tracking consultancy. In the week to May 24, it recorded the biggest net outflows from emerging market funds seen in two years.

“There was some panic and profit-taking simultaneously but that’s natural – the stronger the profits, the more incentive there is to take them,” added Mr Durham.
But most observers are still sanguine.

“I don’t believe the last two weeks are a sign of major risks; it’s a correction,” said Mansoor Dailami, lead author of a World Bank report on global development finance to be released on Tuesday, which shows record private inflows into developing markets.

The run-up in many emerging markets this year alone has been strong enough for the events of the past two weeks not to have undone all the gains. The MSCI EM index is still up 9 per cent this year and 74 per cent since the beginning of 2004.

The recent volatility, however, is still a test of many advocates’ claims that things are different this time for this traditionally volatile asset class.

“The risks are not of the nature of the past; this is not about inflation, it’s not about current account deficits,” said Mr Dailami. Many emerging markets have in fact built up current account surpluses and far more are receiving credit upgrades than downgrades.

Kingsmill Bond, emerging markets strategist at Deutsche Bank, agrees. “Even if foreign money is removed, emerging markets are unlikely in most instances to suffer the impact seen in previous crises.”

The flood of money that has poured into emerging markets in recent years has also changed the nature of the investors, many of whom are now specialists with more understanding, claims Gunter Heiland, an emerging markets bond fund manager at JP Morgan Fleming Asset Management.

“It’s healthy once in a while to have a bit of a pullback,” he said. “This market has changed over the last five years; it’s a very different investor base, a lot is dedicated money and they’re less likely to suddenly sell off.”

Trading in emerging market debt hit a record in the first quarter this year, up 15 per cent from a year ago, according to the Emerging Markets Trade Association.

The World Bank report also highlights the improvements in local markets, the diversification of investment – with a growing percentage coming from other developing markets – and the use of new instruments such as credit default swaps. All have helped to transfer and spread risk and, to some degree, avoid the traditional concentration with a limited number of investors and a handful of very tradeable instruments.

But the report also warns that these are still very young markets that could yet be derailed.

“It’s not evident that they can absorb very large external financial shocks,” said Hans Timmer, head of the bank’s Prospects group.

A key concern for the bank is the risk of a sharp dollar sell-off and widespread market turmoil should concerns grow about the US current account deficit and the resulting global imbalances.

“The biggest risk is from financial markets,” said Mr Dailami. “Part of the anxiety is people have different views of how to deal with global imbalances. That’s an unresolved problem in itself, that we have different views.”

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