US Federal Reserve chairman Ben Bernanke's speech on Wednesday outlined the central bank’s intentions to end quantitative easing by the end of 2014, and yesterday Asian financial markets were in turmoil, with Jakarta's index down 3.7%, Manila down 2.9% and Tokyo's Nikkei 225 down 1.7%. But investors, economists and analysts are confident a 1994-style meltdown is not in the cards.
Analysts have been brushing off their history of how US interest-rate rises in 1994 sparked a series of emerging-market crises, from Mexico to Thailand and ultimately to Russia in 1998, which in turn led to the collapse of Long-Term Capital Management and threatened developed financial markets.
“The events of 1994 are a very important case study for analysts looking for signs of what might happen when, eventually, the Federal Reserve changes course on monetary policy,” according to a research note from the International Institute of Finance from the start of 2013.
It goes on to talk about how the Fed raised its federal funds target rate from 3% to 5.75% over the course of 1994, steepening the yield curve, triggering a stampede out of bonds and prompting private capital to flee emerging markets.
Market turbulence increasing
In the past six weeks, markets have anticipated the end to Fed-generated liquidity, reversing gains in bond prices, particularly in credit and emerging-market debt, as well as in equities.
On Wednesday, Bernanke gave an upbeat assessment of the US economy, anticipating a point when US unemployment will fall below 6.5%, allowing the central bank to initially reduce the size of its monthly asset purchases and, by the end of 2014, cease them altogether.
The yield on 10-year Treasuries hit a 15-month high following his remarks, rising to 2.36%, versus the 1.66% yield recorded six weeks ago.
A lot has changed in 19 years, however, and while the Fed’s exit programme will obsess markets for some time to come, “The strategic case for investing in emerging markets remains solid,” says Alan Brown, London-based CIO at Schroder Investment Management.
In 1994, the Fed’s action was to moderate a strongly expanding economy. Today the US economic recovery remains weak. Still, the nominal move in interest rates is not the important comparison, but the direction and how markets interpret it.
Volatility in financial markets has been high over the past month, since Bernanke first hinted at the Fed’s “tapering” off quantitative easing, reflecting a market retreat among a number of players, says Brian Baker, Hong Kong-based CEO at Pimco.
Brokers and investment banks have responded by slashing their balance sheets. Hedge funds deploying leverage are therefore reducing exposures. Retail investors have been fleeing mutual funds. Institutional investors which in recent years have shifted beyond their traditional asset classes are retreating. And rising volatility is forcing long-only fund managers who rely on value-at-risk metrics to exit markets perceived as risky, including emerging-market bonds.
While the Fed’s policy continues to attract assets to the shorter end of the yield curve, anything beyond five years is also viewed as risky, and market turbulence there will continue, say bond managers.
That is likely to carry on so long as investors continue to de-risk, but there are reasons why it should not morph into a crisis.
Outflows won’t be extreme
Firstly, how close are we to investors wrapping up their selling activity? Research published yesterday by Bank of America-Merrill Lynch calculates the average fund manager’s EM allocation is below 10-year averages, suggesting the sell-off could dissipate.
Moreover, foreign exposure to Asian capital markets is not extreme. RBS research published on June 6 shows that the pace of foreign investment over the past five years has been measured, in contrast to frenzied entries in the 1990s, relative to Asian country GDP.
In other words, investment into Asian stocks and bonds has been strategic, and has also come after a decade’s worth of outflows. Investors overall remain well underweight Asian markets. The extent to which Asian economies recover along with the US will determine how much more selling remains in the cards, but RBS doesn’t expect a rapid or massive capital outflow.
Secondly, as yields do rise, this will attract long-term, liability-driven investors such as pension funds and insurance companies, to deploy cash. This is particularly true in Asia, where asset levels are vastly greater than in the 1990s and where there are far more institutions building Asia-wide bond portfolios (see Asianinvestor's upcoming July magazine for our latest rankings of Asian institutional investors by AUM). Also, the Bank of Japan’s own QE programme is just beginning, and gradually over the next few years, big Japanese investors are likely to enter Asian markets.
Thirdly, the Fed is a different animal today than it was in the 1990s: “The Fed’s communication policies have evolved,” says Pimco’s Baker. Today the central bank engages with market participants and the media, and is transparent with regard to its internal decision-making. That’s a big difference to how it sprung the 1994 rate hikes upon an unsuspecting market.
Finally, emerging markets today cannot be lumped into a generic pool. Investors are more aware of markets’ individual quirks and foibles, from Chinese liquidity problems to inflation-led street unrest in Brazil.
And that means opportunities as well: Schroders’ Brown notes that India’s ability to moderate inflation means the Reserve Bank may have scope to loosen its monetary policy, bucking the global trend. “We can’t treat these markets as a homogenous asset class, like we used to,” he says.