Erich Bauer-Rowe Comments: Mr. Bernanke’s Blessing

December 13, 2012, Financial Times

If there were any fears that the EM assets boom seen over the past year – particularly in fixed income – could peter out as valuations get stretched, they have been more or less put to rest by Ben Bernanke’s latest actions. The chairman of the US Federal Reserve on Wednesday announced another round of monetary easing, a move that will add to the flood of hot money that has been making its way to EM assets.

The measures announced by Bernanke include:
• boosting the Fed’s bond-buying programme to $85bn a month. He said it would buy $45bn of Treasury bonds in addition to its current commitment of buying $40bn of mortgage-backed securities each month.
• linking interest rates to unemployment and inflation levels. Bernanke expects to keep interest rates close to zero until unemployment falls below 6.5 per cent and as long as the Fed’s inflation forecast stays below 2.5 per cent a year.

So, 14 economies, with a combined equity and bond market cap of $65 trillion, now have zero interest rates. For EMs, this is both good and bad news. Good, because the lust for yields will continue to drive inflows into the asset class. Some of that liquidity will trickle beyond investment grade EM bonds and into equities and other risky assets.

The bad news is that all this hot money will intensify the compression of yields and further distort price-risk relationship for investors. Not to mention the effects of a weak dollar on EM currencies. Currency war, anyone?

This from Derrick Irwin, portfolio manager at Wells Fargo Advantage Emerging Markets Equity Fund:This is likely to provide a short term bounce in emerging market equities, but longer term it suggests a low growth low rate environment will continue. This should manifest in continued distortions in global equity markets as investors increasingly ignore valuations in their search for higher yielding assets.

Elsewhere, Erich Bauer-Rowe, co-head of the emerging markets group at Cantor Fitzgerald & Co, has this to say:The announcement reinforces the view that rates will remain low. Therefore inflows to EM funds will continue at a robust pace as investors reach out for yield. One can argue that some credit valuations look stretched in EM, but the wall of cash waiting to be invested is real and will continue to look for a home.

As cash is put to work in EM and spreads tighten, I expect investors to look for alternatives in other areas. The European markets have already shown a marked improvement. However, EM is no longer a single class bond market. You have a high grade/high yield sectors and that combined with a large local markets component. Therefore investors will still enjoy a wide range of Beta within the EM world.

The MSCI Emerging Markets Index rose 0.5 per cent on Wednesday and is up another 0.66 per cent on Thursday at 1,041.37. Meanwhile the JP Morgan Emerging Markets Bond Index closed at 670.447 on Wednesday, just shy of the record high of 670.613.

But there are those who think EMs are becoming too crowded of a trade. Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch says:The market is starved for yield and investors have poured money into any bond anywhere that offers a coupon. Assets under management at high yield, Emerging Market and MBS funds have simply soared this year. One of the best performing EM debt classes year to date is distressed, up 31%. And this yield-grab has now even extended into Frontier Markets, where bond issues in Zambia and Angola were oversubscribed. Indeed, a municipal bond issuance for Lagos, Nigeria raised $2 billion (with a 14.5% coupon).

The 1994 analog, when a surprise surge in growth caused a nasty bear market in bonds, remains our worry given the manifold similarities between 1993 and 2012. But watch FX volatility very closely from here, especially in Asia, the major region financing the US current account deficit.

Indeed, as beyondbrics has discussed in previous posts, with EM bonds being sold and snapped up at record low yields, the danger for investors is what will happen once the Fed and other central banks begin raising interest rates again.

New issuers would be forced to offer higher yields, forcing down the resale value of EM bonds that were issued during the current frenzy and potentially delivering a huge blow to portfolios that are holding this paper, particularly high yield junk bonds.

“The analogy I would use for the current interest rate environment is that of a balloon being held under water,” Scott Minerd, chief investment officer at Guggenheim Partners, told the FT’s Michael Mackenzie and Stephen Foley. “When the Fed withdraws from the market and allows interest rates to find their economic level, the balloon will inevitably ascend.”

Minerd was talking about the general US corporate bond market. But the analogy could apply to the EM bond market as well.