Jitters Over Rising Interest Rates
Tuesday, May 23, 2006
Stocks in developing countries tumbled yesterday, extending one of their biggest losing streaks in nearly a decade, as growing jitters about the global economic outlook amid rising interest rates prompted investors to abandon riskier markets world-wide.
The pullback in markets as far-flung as Turkey, India, Russia and Brazil has broad ramifications for U.S. investors. Emerging-market stocks have been the world’s top performers over the past three years, soaring nearly 200%, based on the Morgan Stanley Capital International Emerging Market Index, a key yardstick. During that period, U.S. investors, led by hedge funds and more aggressive mutual funds, have poured money into even the riskiest countries at a record pace in search of better returns than they could obtain at home.
Yesterday, as many of those same investors sold across the board, some of the highest-flying emerging markets became the biggest losers. Russia’s RTS Index declined 9%, and the Turkish market fell 8%. By midday in India, stocks were down 10% — enough to trigger an automatic halt to trading there — though they came back later to close down 4.2%. Some analysts speculated that government-controlled investment funds started buying to bolster the market.
Overall, the MSCI Emerging Market Index fell 4.6% yesterday, its largest one-day decline in two years, erasing $86 billion in market capitalization. The index has declined 15% since hitting its highest level ever just two weeks ago. Emerging-market bonds have also taken a hit over the past two weeks, and currencies like the Turkish lira and the Brazilian real have retreated more than 9% against the dollar.
Driving the sell-off: Expectations that central banks around the world, from the U.S. to Europe and eventually Japan, may be preparing to raise rates more aggressively than previously anticipated. News last week that the U.S. consumer-price index rose faster than expected raised the specter that interest rates will have to climb further to curb inflation. Even the recent retreat in commodity prices has not been enough to blunt inflation fears, and since many developing countries are commodity producers, these declines have weighed on their economic outlooks. (See related article3.)
Selling by hedge funds and other more speculative investors is aggravating emerging-market losses. These investors, who aim to lock in short-term gains, will often sell their best stocks to ensure profits and cover any losses in other positions. So a selloff in India may cause pain in Russia or Brazil, despite different economic outlooks and stock valuations.
And given the current global economic scenario, “these markets are going to be in for a rough couple of months,” said Carlos Asilis, a Miami-based portfolio manager for Vega Plus Capital Partners, which has $2 billion under management.
The ripple effects are being felt in developed markets. Yesterday in Europe, the London market’s FTSE 100 Index fell 2.2%, the German DAX Xetra 30 Index fell the same, and the French CAC-40 Index slid 2.7%. And while the Dow Jones Industrial Average slipped just 0.2% yesterday, stocks have been down sharply since May 10, when the Federal Reserve indicated it may not be done raising rates. U.S. government bonds — considered the least risky investment — edged higher as some investors sought safety. (See related article4.)
A big contributor to the rout in emerging-markets stocks can be traced to Japan, where central-bank officials earlier this year indicated they were preparing to end a long period of near-zero interest rates. Those extraordinarily low rates — part of Japan’s effort to pull out of a decade-long economic slump — had become an important and lucrative tool for savvy global investors in recent years. Many investors had been borrowing money in Japan (at almost no cost to them), and then investing in high-yield debt in New Zealand, Iceland, Turkey and other overseas markets. The popular maneuver became known as the “carry trade.”
One of the first signs that the prospects of higher interest rates were unraveling this strategy struck Iceland in February, when vast sums of foreign money were pulled out of that tiny economy, sending the stock market and currency tumbling there. Since then, gold and other commodities have also been slumping after big run-ups in recent years.
While emerging markets haven’t been battered this badly since the financial crisis of 1997-98 — when a series of Asian currency devaluations and Russia’s debt default roiled markets around the world — fund managers point out that much has changed since then. In the intervening years, many developing countries have turned trade deficits into surpluses and have allowed their currencies to trade more freely, giving their economies greater flexibility and helping to insulate them from selloffs as violent as those of the past decade.
“That theory is now being put to the test,” says Jack Ablin, chief investment officer for Harris Private Bank in Chicago, with $48 billion in assets under management.
He remains cautiously bullish on emerging-market stocks, with 10% of the firm’s stock portfolio still invested in developing countries. His reasoning is that share valuations still look more attractive in these markets than in the U.S. Also, emerging-market economies are expected to grow faster than developed economies in coming years. India, for example, is still expected to record some of the strongest economic and profit growth in the world this year.
Nevertheless, many hedge funds — lightly regulated investment pools that cater to wealthy investors — have decided that after years of profiting in emerging markets, there’s little incentive for them to stick around to see what happens next. In recent days, they have been among the markets’ most active sellers, though they could easily jump back in when they see brighter prospects. Mr. Asilis, the hedge-fund manager, says it would take a 15% to 20% drop from current levels to tempt him to buy emerging-market stocks.
Some investors said they are simply selling and hoarding cash until things calm down. Vladimir Milev, an analyst for the Metzler/Payden European Emerging Markets Fund in Los Angeles, said that 20% of his $90 million fund is now in cash, up from nearly nothing a month ago.
Whether emerging-market fever among U.S. individual investors will persist after the recent declines remains to be seen. In 2005, these investors poured a record $13.8 billion of net new money into emerging-market stock funds, according to AMG Data Services — a record surpassed in just the first four months of this year. As of last week, investors had put $19 billion into these funds.
Russia’s stock market, one of the hottest performers this year as investors flocked to companies like state gas monopoly OAO Gazprom, was among the hardest hit yesterday.
“This is part of a global trend,” said Chris Weafer, analyst at Alfa Bank in Moscow. “$30 billion has been absorbed into global emerging markets to date this year, compared to just over $20 billion for all of last year. That’s driven markets up faster and higher.”
–Eric Bellman and Gregory L. White contributed to this article