‘Violent’ emerging market sell-off coming

The hedge fund that beat 99% of peers last year with a bearish stance on emerging markets says the selloff since February has proven its scepticism right, and risky assets will face even bigger losses later this year.

Man Group, the world’s biggest publicly listed hedge fund, told Bloomberg in February that the rally in emerging markets between October and January wasn’t justified by economic fundamentals and was set to reverse.

The prediction proved correct, with sovereign dollar bonds from emerging markets handing investors a 2.2% loss since then and the benchmark MSCI emerging-markets equity index falling almost 7%.

EM Risk Perception Worsens | Developing nation dollar bond spreads have widened since February
“Our argument is still pretty much in play,” said Guillermo Osses, the firm’s head of emerging-market debt strategies in New York.

“We have one of the most defensive positions we have ever had.”

Osses said temporary rallies earlier this year were simply a consequence of dollar-liquidity dynamics as policymakers sought to contain spillover from the collapse of Silicon Valley Bank.

His bearishness contrasts with other Wall Street firms, including BlackRock and the asset-management units of Morgan Stanley and JPMorgan Chase & Co., which have recommended investing more money in emerging markets. Goldman Sachs Group Inc. also has a positive view of EM currencies.

So far this year, the reopening of China’s economy, a weaker dollar and easing inflation expectations worldwide haven’t translated into the kinds of returns that bullish emerging-market debt and equities investors expected.

The MSCI Emerging Markets Index has underperformed the S&P 500 this year, with gains of 1.5% and 5.6%, respectively.

Man Group’s bearishness hasn’t paid off, either. According to data compiled by Bloomberg, its emerging-market debt fund lost 1% this year and has been beaten by nine out of 10 peers.

Osses declined to comment on fund returns, citing company policy.

But he reiterated his conviction that emerging-market bond spreads, currencies and rates have been primarily driven by US liquidity rather than changes in the macroeconomic outlook for developing countries.

Liquidity Drain

The following six to nine months will prove starkly different, Osses said, predicting a massive liquidity drain as the Federal Reserve continues to tighten monetary policy and as the US Treasury’s cash balance increases — something that should happen if and when the debt-ceiling impasse is firmly resolved.

Along with raising interest rates, the Fed has been working over the past year to reduce the size of its balance sheet by letting some of its maturing bond holdings roll-off, a process known as quantitative tightening.

This year, an uptick in emergency lending to banks reversed part of that balance-sheet shrinkage, but that effect is fading as facility use diminishes.

Meanwhile, the Fed’s bond pile is shrinking by around $95 billion monthly. That equates to about $1.1 trillion of tightening a year if the central bank keeps at it, something it could do even if it hits pause on interest-rate hikes.

In Osses’s view, the impact will only be compounded by a rebound in the Treasury cash balance on the heels of a debt-cap solution eventually being reached.

He is not the only one ringing alarm bells on Wall Street.

“Liquidity conditions largely drive the rally in the markets over the past few months,” said Olga Yangol, head of emerging market strategy for Credit Agricole SA in New York.

“We expect the resolution of the debt ceiling impasse, the onset of the cyclical credit crunch, and potentially higher-for-longer Fed funds rate in the context of inflation persistence to send this into reverse. Therefore, we are underweight EM FX risk vs the dollar in our EM FX portfolio.”

Risk Assets

The widening in bond spreads in emerging markets “is going to be much more violent than the one that we saw in early 2022,” when Russia invaded Ukraine, Osses said.

According to a Bloomberg index tracking corporate and sovereign dollar bonds, emerging-market debt lost 15% that year, its biggest annual loss since at least 1994.

“When you look at what we expect to happen in six to nine months, from a risk-reward perspective, it’s tough to have significant exposures because everything is going to play against risk assets,” he said.

He said an additional challenge is posed by Japan’s central bank, which may relax its government bond yield control, reducing demand from the country’s institutional investors for emerging-market debt.

Market metrics in distressed countries in Africa, the Middle East and South Asia represent the risks facing emerging-market investors because lower-quality credits have already been cut off from international borrowing markets, and prices reflect that, Osses said.

“As this liquidity drain gets deeper, the situation is going to become more challenging,” he said, particularly for any developing-nation policymakers who operate as if the liquidity they’ve become accustomed to over the past few years will still be available.

“We think that they haven’t realized that this is about to change abruptly and that it’s already changing.”


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