People are nervous about emerging markets. You know that. I know that. Everyone knows that. And everyone plus you and me also knows why people are thusly nervous.
It’s because after years of benefiting from flows facilitated by unprecedented accommodation by DM central banks, the tide is starting to turn and even if lackluster data in Europe and a generalized deceleration across developed economies means the U.S. ends up being the proverbial “last man standing“, the Fed is likely to stay the course on hikes thanks ironically to the fact that the very same late-cycle fiscal stimulus that makes it possible for the U.S. expansion (already the second longest in recorded history) to continue, also raises the risk of inflation pressures building.
And so, Jerome Powell will stick to his guns (until he doesn’t) and that means more hikes and higher short rates and higher real rates and rising 10Y yields and a stronger dollar and perhaps a shortage of dollar liquidity (i.e., a prolonging of the funding squeeze that unfolded in Q1), and on and on.
None of that bodes well for EM and the recent run on the Argentine peso and Turkish lira perhaps provide something in the way of a preview of what happens when inherently precarious idiosyncratic stories in the developing world collide with Fed normalization. There’s also trouble in Indonesia and Hong Kong, with the latter seemingly vulnerable to capital flight and the possibility that higher rates could end up bursting bubbles that inflated on the back of abundant liquidity.
“It has been striking to see market participants suddenly becoming aware of the often indirect mechanisms which meant that in prior years an abundance of $ liquidity drove up asset prices, and of the potential for these processes now to run in reverse,” Citi wrote in a recent note.
But the primary question (which is: will the ongoing dollar rally and an aggressive Fed continue to destabilize EM by undercutting the dynamics that fueled the carry trade?), another question is this: who’s been selling recently?
The answer, according to JPMorgan’s Nikolaos Panigirtzoglou, is the smart money. To wit, from a note out Friday:
EM dedicated hedge funds appear to have been mostly responsible for the recent EM correction. This is shown in Figure 1 which depicts the beta of EM dedicated hedge funds proxied by the HFRX EM Composite Index vs. the JPM EM currency index. EM currency exposure represents an important component of both EM equity and EM bond exposures and thus the single best metric to assess EM hedge fund betas.
Figure 1 shows a big and abrupt drop in EM hedge fund beta to the EM currency index for the most recent period since April 19th, pointing to currently low EM exposure and the lowest since last November. Effectively, the entire previous rise in the EM hedge fund beta seen between November last year and March this year has been unwound in recent weeks.
Here’s the JPM EM FX index for reference purposes:
Contrast that drop-off in the most recent period in the third column of Figure 1 above with the relatively stable betas in the following two tables for real money EM managers (proxied using the 20 largest EM active equity MFs and the 20 biggest EM active bond MFs):
As Panigirtzoglou notes, “in contrast to hedge funds, real money EM managers do not appear to have lowered their beta over the past two weeks.”
He goes on to suggest that recent outflows from EM equity and bond ETFs (i.e., retail money) haven’t been that large on an aggregate basis.
In case it isn’t clear enough where they’re going with this, the idea is that if the “smart” money has been doing all of the selling thus far, more pain for the space could be in store if the more sticky real money starts to sell.
As usual, the last people to get the message will be retail, although maybe not because thanks to ETFs, “dumb” money can trade in and out of previously esoteric asset classes easier than ever before. “Dumb” money is now also “hot” money in some cases. It’s now “smart, not like everybody says.” Cue Fredo.
EM selling is not overdone and that EM assets look still vulnerable if real money investors decide to join hedge funds in reducing their EM exposure.
Or actually don’t – because if the above is right and you sell, then you’ll end up exacerbating the situation. Don’t be an asshole, ok?