THE boom in emerging markets (EMs) has led to caution among investors looking for safe haven assets, especially in view of potential volatility sparked by US rate hikes. And yet there are insufficient safe haven, risk-free assets in (EMs) that investors can hold as stores of value when times get rough.
“China and other developing nations are accumulating wealth, but failing to create sophisticated local markets that feature their own risk-free instruments.
“That’s left a dangerous reliance on US Treasuries, perpetuating a bond bubble and pushing investors into riskier assets,’’ said Bloomberg, quoting strategist and hedge fund manager Stephen Jen.
“Many investors here are turning to developed markets for investments.
“The risk is higher in EMs as their central banks have far less control over domestic financial markets,” said Inter-Pacific Securities head of research Pong Teng Siew.
Rally in EMs fizzling out?
“We have a confused market right now. The KL benchmark index is poised to climb further but technology stocks, which led the market up initially, are unable to climb anymore. This is due to the stumble on Nasdaq after its relentless climb,” said Pong.
“So far, markets have been more resilient than I expected. They are holding up into June despite the expected slowdown in US and China economic numbers.
“I still think markets are ripe for a retracement but (availability of) liquidity could prove me wrong for longer than I am comfortable with,” said Etiqa Insurance & Takaful head of research Chris Eng.
“While the global economy is picking up in a more synchronised way, commodity-related EM economies are now bracing for a moderation in commodity prices.
“While the US economy gathers strength, its divergence from EM economies would mean that volatility in capital flows may re-emerge, and may lead to financial market instability,” said Malaysian Rating Corp chief economist Nor Zahidi Alias.
“Such a scenario would mean that investors will continue to focus on US dollar-denominated assets. From an asset allocation point of view, investors may start to shy away from equities again,’’ said Zahidi.
Untapped market for safe haven assets
In EMs, there is a lack of supply of assets such as liquid bonds or debt securities that investors can confidently hold onto in times of uncertainty.
“Due to this limited supply, investors would continue flocking towards safer assets in advanced economies such as US Treasuries, German bunds and British gilts.
“The flight to quality also includes hard currencies such as the US dollar, yen and gold,’’ said Socio Economic Research Centre executive director Lee Heng Guie.
Central banks in EMs have also invested foreign reserves in safe haven assets in advanced economies. “This indicates that there is a huge, untapped market in Asia to create an asset class of its own. Hence, it is vital for emerging economies to foster deeper integration of financial markets to recycle Asia’s surplus savings into the region and help to develop a viable, liquid and deeper local currency government bond market,’’ said Lee.
Guarding against volatility
Soft reports on employment and inflation in the US may lead investors to ease up on bets for additional rate hikes but central banks in Asia are rebuilding their foreign exchange reserves in case of aggressive Fed moves that can spark volatility and cause jitters.
China is leading the turnaround with its resumed purchases of US treasuries while sizable gains in foreign reserves have been notched in Malaysia, Indonesia and Singapore.
India’s foreign-exchange reserves are at record highs, buoyed by strong inflows into the stock market, said Bloomberg.
“In the event of tight liquidity and shortage of US dollars, regional central banks can tap on currency swap arrangements set up between them.
“The swap lines are important to reassure creditors that US dollar funding is available, as central banks hope to head off further US dollar funding liquidity shortages.
“The swaps are essentially put in place in a preemptive manner as their presence would provide a backstop for US dollar funding markets and help bolster confidence,’’ said Lee.
“Emerging markets have been trying to cushion the impact of Fed rate hikes by paring down credit growth and borrowings, as most developing nations saw their annual credit to gross domestic product (GDP) slip.
“EMs have remained resilient in the face of gradual Fed rate hikes; the MSCI EMs Index has performed relatively well since the Fed hiked its rates for the first time in December 2016.
“Investors should monitor the respective external balances and credit-to-GDP ratios of EMs, as these data would indicate how well they can withstand the impact of gradual US rate hikes,’’ said Fortress Capital CEO Thomas Yong.
Columnist Yap Leng Kuen notes that central banks have been described as “stacking up the sandbags” in preparation for any flood of volatility.