INVESTMENT FOCUS-New emerging market rush may spell trouble ahead

LONDON Fri May 16, 2014 9:58am EDT

LONDON May 16 (Reuters) - Emerging markets are among the biggest beneficiaries of a fresh rush for riskier assets by yield-hunting investors but almost indiscriminate demand today may be sowing the seeds for a bigger sell-off in future.

Undeterred by poor growth prospects, money is pouring into developing economies - from stocks and dollar debt to credit products - as expectations major central banks will extend their monetary support revive enthusiasm for the asset class.

The European Central Bank is widely expected to become the latest to cut interest rates next month, to underpin fragile growth in the euro zone. Fed chair Janet Yellen has said the U.S. economy needs support, while expectations have been growing that China too might unveil stimulus.

Analysts and strategists have been at pains to stress since sell-offs in May/June last year and January 2014 that emerging markets are not an homogenous group and have urged investors to differentiate their idiosyncratic risks.

But now the exact opposite seems to be going on.

"To me, the message is clear: buy EM assets and don't spend too much time picking and choosing. We are back to a directional market so I don't want to waste my time looking at relative values in EM FX," said Benoit Anne, head of emerging market strategy at Societe Generale.

"Likewise in EM rates, outright receivers and/or buying cash bonds is the right approach, as opposed to curve views."

A receiver is a common form of interest rate swap, while curve views refer to the buying and selling of bonds with different maturities.

According to EPFR data, investors put $400 million into emerging equity funds in the week ending May 14, while EM bond funds drew in $1.2 billion. Emerging bond funds pulled in investors for the seventh consecutive week.

"The good old carry trade is back," said Maarten-Jan Bakkum, emerging market strategist at ING Investment Managers, referring to high-yielding investments funded by borrowing at rock-bottom rates. "It's a very dangerous environment to be short EM.

"Given how U.S. and European yields are moving, it's not a bad idea to be overweight if you are happy to go in for a few weeks, take the gains and exit. But it's not a position you want to hold for a longer time."

Year-to-date flows into EM equity funds are still negative at $30.5 billion, more than double total 2013 outflows of around $14 billion. Bond funds have shed $7 billion this year, after outflows of $14 billion in 2013.

CASH GENERATION

Flows, of a somewhat short-term nature, may be coming in but EM economies themselves are not generating cash, according to data from London-based fund CrossBorder Capital.

CrossBorder Capital's index of aggregate liquidity - the amount of money available in financial markets - in the EM private sector stands at 18 out of 100 against 70 for developed economies. Liquidity is not universally low in EM, however, with the Philippines index at 83 and Korea at 76.

Aggregate liquidity tends to lead asset performance by six months, with a lower index score highly predictive of market declines.

"Evidently, fundamentals come back to tell a rather different story," CrossBorder managing director Mike Howell said. "There is little total cash generation of the economy passing through the financial markets because central banks (policies) are tight."

Two-thirds of EM central banks are currently running monetary policy that is tight relative their average, he added.

"If their economies are slowing down significantly, then money is going to start to exit again. When money panics, interest rates are not important breaks (to stop the rapid outflow of cash)," Howell said.

"I think a further 10 percent devaluation across the board in EM currencies is warranted." (Additional reporting by Sujata Rao; Editing by Catherine Evans)