Has there been a faster round-trip than the consensus opinion towards the emerging markets? Today's Wall Street Journal is rife with articles on the plunge in the emerging markets. The question is whether any one should really be shocked by this reversal in fortune. We are waiting anxiously for the emerging markets to grace the cover of some major business magazines to finally close the loop.
We have been on the case of the emerging markets for some time now. The question has not been whether they were in a far better financial and economic position. The question has been whether the hot money, i.e. hedge funds, had driven them too far, too fast. The launch of BRIC funds was probably a good sign the emerging markets meme had gone a bit too far.
That is not to say that this emerging markets swoon is without some explanation. Every major market move needs one. Kirshna Guha in the FT.com covers some comments by IMF Chief Economist Raghuram Rajan on the role hedge funds have played in driving up the price of risky assets in a low-return world. According to Rajan the reversal of low interest rates is likely to increase risk aversion and increase volatility in these markets.
But when global interest rates rise and liquidity diminishes, incentive structures no longer favour piling up as much risk, driving asset managers to cut back on their holdings of risky assets, thereby pushing up their price. He said this could result in wild swings in the value of emerging market assets – which plunged on Thursday – that had little or nothing to do with the economic fundamentals of the emerging markets themselves.
This so-called risk shift makes the markets vulnerable because many hedge fund managers have simply been taking on illiquidity risk to generate faux-alpha. When the conditions for this worsen they get nervous.
Mr Rajan argued that most investment managers are rewarded for generating “alpha” – returns over and above those attributable to taking on “beta” or market risk – but find it very difficult in practice to do so. Mr Rajan said that, in practice, most asset managers generate “poor man’s alpha” by taking on liquidity risk – holding illiquid assets to maturity. To do so, they need access to liquidity themselves. “Extremely accommodative monetary policy, as well as a sense that policy will stay accommodative, engenders illiquidity-seeking behaviour,” Mr Rajan said.
A piece by Craig Karmin in the Wall Street Journal attributes the fall-off in the broader global markets to the fear that rising interest rates will precipitate a slowdown in the global economy. Given the broad-based pullback in the emerging markets, including the emerging market bond market, we find the risk-shift argument more compelling than the standard economic argument for a slowdown.
Gregory Zuckerman and Ian McDonald in the Wall Street Journal document the toll the fall in the emerging markets has taken on hedge funds. A growing number of hedge funds had piled into the red-hot emerging markets in pursuit of non-correlated returns.
"Hedge funds will go for returns wherever they can find them," said Emmett Ryan, principal of Southport Management Group, a hedge-fund consultant. "Those markets were moving, and hedge funds were the ones moving them."
The challenge was that it was easier to get into the emerging markets than it was to get out in a hurry once the writing was on the wall. This theme of getting out spilled over into the personal investment section of the Wall Street Journal. As with most articles of its type it presents advice on both sides of the issue. Some saying it is time to bail, others saying stay put. This only exacerbates the confusion on the part of naive investors who really did not know what they were buying when they initially invested in an emerging markets fund.
The old saying goes, "don't confuse brains with a bull market." The emerging markets were in a bull market. Now they are not. Hot money drove these markets beyond where they probably should have been. The question is whether they will soon drive them below were they should be now.
The trifecta of articles on the emerging markets in today's WSJ may not be a sign of the bottom, but it indicative that some fear has finally been injected back into the market. What we don't know is to what degree the hot money that drove the markets higher is lurking about, looking for a better exit. This would thwart any sustainable upwards move.
For those with a longer term time horizon and well-diversified portfolio an emerging markets equity fund is a logical piece of the puzzle. A pullback in the markets should not be a time for panic. For those with a portfolio re-balancing mentality they would have been trimming these positions previously. Now they can begin looking forward to add to their emerging market positions in the future.