August was a rough month for emerging markets. If you need the details on that, you’re encouraged to check out “Battered And Bruised After Rough Month, Emerging Markets Warily Eye The Road Ahead“, published here on Friday evening.
It’s difficult to disentangle this situation. There’s a bit of a chicken-egg problem at play. Obviously, Jerome Powell was incorrect when he said the following at an IMF/SNB event in May:
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
Suffice to say the ongoing normalization of Fed policy has not proven to be entirely “manageable” for EMEs. As far as whether developing economies are “surprised” by the Fed’s actions, I think the more relevant question is this: Are EM policymakers surprised at the Fed’s apparent unwillingness to account for the interplay between current fiscal policy and U.S. monetary policy when it comes to driving the dollar higher? My guess would be that the RBI’s Urjit Patel and Bank Indonesia’s Perry Warjiyo are indeed at bit incredulous in that regard.
But getting back to the chicken-egg problem, it’s not entirely clear which has been more detrimental to EM sentiment, the acute flareups in Argentina and Turkey or the more general problem that comes along with the external shock from tighter Fed policy. Indeed, if you zoom in on Argentina and Turkey, it’s hard to say whether the collapse of the peso and the lira represent the culmination of structural problems or whether they were simply the wobbliest dominos in a space that was vulnerable to the reversal of the global hunt for yield.
Whatever the case, we’ve got a problem on our hands with EM. Equities fell into a bear market last month and the currency space was a veritable bloodbath in August.
One natural question after August is this: Who was selling?
Well, if you ask JPMorgan, the answer is the institutional crowd. “On our metrics EM local currency bond managers appear to have been mostly responsible for the recent EM correction”, the bank’s Nikolaos Panigirtzoglou writes, in a note dated Friday.
According to JPMorgan’s estimates, local currency active bond funds were overweight going into July and that exposure increased throughout the month. That, the bank says, left local currency bonds and EM FX vulnerable headed into last month.
“Figure 2 shows that those local currency bond overweights had reached high levels in July relative to their average over the past five years [but] the increase seen in July appears to have been unwound abruptly in August”, Panigirtzoglou writes, adding that “in fact, not only does Figure 2 suggest that EM local currency bond managers have reversed July’s OW, but it also suggests that this reversal during August has been so acute that they likely entered capitulation territory.”
The bank goes on to say that when it comes to hard currency bonds, managers actually turned overweight in August, while EM equity managers who flipped to overweight in July pared their exposure a bit last month, but not anywhere near what you see in the local currency fixed income space (chart above).
Retail investors, on the other hand, don’t look to have done much at all on a net basis. “Figure 6 shows that EM bond ETFs resumed small outflows in August following a modest inflow in July [while] EM equity ETFs saw an inflow in August following a flat July and strong outflows in May and June”, Panigirtzoglou continues, on the way to concluding that “it looks like retail investors were not the ones responsible for the EM correction in August.”
So place the blame with institutional investors if you like and add a jump in short interest in the largest EM local currency bond ETF for good measure when it comes to flagging signs of capitulation in local currency debt.
What does it all mean? Well, according to Panigirtzoglou, it means this:
In all, there is evidence of capitulation in EM local currency bond space. In contrast, active EM equity and hard currency bond fund managers continued to exhibit rather elevated betas during August, suggesting that the EM equity and hard currency bond universes are more vulnerable in the event of re-escalation in the US-China trade conflict into September.
Given that, it’s a good thing there are no indications that another escalation between Washington and Beijing might be imminent.