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Mohamed A. El-Erian Headshot

Investors View Emerging Markets Through Jaundiced Eyes

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The investment narrative for emerging markets has shifted, markedly and rapidly.

Having been viewed until recently as a promising destination for investors, the asset class is now experiencing significant outflows. And, having been previously characterized as reliable engines of global economic growth, emerging economies are now seen as more volatile and as contributing less to corporate earnings and profitability.

Many government officials in Asian and Latin America are, I suspect, quite frustrated and concerned about this shift. After warning of the potential instability that they were importing as a result of the West's experimental monetary policies, they are dealing with some of the consequences. Understanding their frustration is a useful point of departure for assessing what lies ahead.

The bullish secular case for emerging economies was based primarily on their stronger growth fundamentals, technological leapfrogging, considerable balance sheet resilience and responsive economic management.

The investment case was further bolstered by the scope for long-term portfolio re-allocations in favor of the asset class. After all, emerging economies were (and are still are) under-represented in benchmarks, especially those based only on market capitalization.

Importantly, a third factor was in play.

Broader investor interest, and the related surge of capital flows into emerging markets, were turbocharged by much more than "pull" factors. A strong push factor was also in play: Rather than reflect an understanding of fundamentals in emerging markets, a portion of investable funds ended there because they were pushed out of the U.S. by repressed interest rates, as well as out of Europe due to credit concerns in European peripherals and very low interest rates in Germany.

It is this third factor that has long concerned officials in emerging economies; and it is behind the sharp shift in narrative. In the process, it complicates the evaluation of future investment strategies for emerging markets. So let us dig a little deeper.

For quite a while, countries like Brazil complained that the West's experimental monetary policy constituted a source of potential financial instability--both for individual emerging economies and for the global system as a whole. The longer central banks sought to floor interest rate at artificially low levels--particularly through large-scale asset purchases (or "QE") and, to a lesser extent, aggressive forward-policy guidance--the more investors would look to flee financial repression by investing in emerging markets.

Their complaints were dismissed by most of their Western counterparts using a mix of arguments.

Some acknowledged the potential risks but argued that the overall impact on emerging markets would be more than offset by the benefits of the global economic recovery ensuing from unconventional monetary policies. Others felt that emerging economies could (and should) minimize the risks by adjusting their own policies. And most hoped that the whining would stop lest it added to the growing global ruckus about the "costs and risk" of unconventional monetary policy.

With emerging markets experiencing both strategic and tactical asset reallocations--the "dedicated" investor base grew, and flows from the much larger "crossover segment" (retail, hedge funds and institutional) increased even more--the resulting flood overwhelmed countries' ability to absorb the funds in a productive and orderly fashion.

Risking credit bubbles and excessive currency appreciation, emerging economies responded with a series of policy reactions. They also sought to financially "self-insure" by accumulating large international reserves.

Their response proved insufficient to fully offset potentially-reversible external influences. As such, the asset class proved technically vulnerable to the sentiment change that started on May 22 when the Federal Reserve signaled its intention to "taper" its balance sheet support for the economy and for markets--and to do so despite evidence that the U.S. was yet to approach escape velocity.

History tells us that bad technical--that is, unbalanced investor positioning and the related risk of quick and disorderly unwinds--can be particularly disruptive in the short term for a sector that, like emerging markets, has a large proportion of new and tactical investors.

Accordingly, the real question today for long-term investors has less to do with the quasi-inevitably of short-term volatility that comes from expectation of monetary policy shifts in the U.S., and more with whether these short-term bad technicals will contaminate longer-term economic fundamentals.

Not all emerging economies are alike in this respect. Many possess sufficient balance sheet strength and can use reserves to help navigate short-term instability. Some, such as Mexico, have stepped up structural reforms to improve the responsiveness of their economies. But there are economies with insufficient domestic shock absorbers and lagging policy responses--thus elevating the risk of currency depreciation and rising bond yields compromising economic stability and prospects.

So, in addition to assessing the potential duration of this phase, investors would be well advised to consider carefully at least two other issues: how the dedicated investor base will respond to the continued exit of crossover and fast money, and whether cyclical economic bumps spot will undermine the secular upside.

Our analysis points to the possibility of further technical instability in the short-term, along with price overshoots (i.e., movements beyond what is warranted by the underlying fundamentals). The resulting price action could also serve to further muddy (rather than make clear) market perceptions of the considerable differentiation that already exists.

As such, this period of instability is also likely to offer investors over time attractive entry points into higher-quality emerging market positions. Indeed, and despite the likelihood of further short-term headwinds, we are already see isolated pockets of both short- and long-term value.

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