LONDON (Reuters) - The looming U.S. fiscal cliff of tax rises and spending cuts combined with renewed euro zone tension over Greece are threatening demand for riskier emerging market assets, just when some are getting expensive.
It is all making the asset class vulnerable to a pullback.
Once high-yielding bonds are offering less than they were and although emerging equities have performed less well than fixed income, some sectors within them are looking pricey.
Emerging sovereign debt, for example, has enjoyed returns of 16 percent this year, outstripping most of the developed world. As a result, yields have fallen dramatically.
“The market has rallied a lot, it’s much less compelling to invest now, for a 4 percent yield,” said Sergei Strigo, head of emerging debt management at Amundi.
“Since the beginning of the year, (yield) spreads have tightened by at least 180 basis points in places like Romania.”
Data from Boston-based fund tracker EPFR continues to show net inflows into emerging bond funds, as has been the case for every month this year. Emerging equities have also enjoyed consistent inflows for the past few months.
But market participants are starting to get more cautious.
Morgan Stanley analysts, for example, cut their recommendation on emerging market assets to “hold” from “accumulate” ahead of the U.S. election last week, for the first time since June, and maintained that position this week.
Investors have flocked to emerging market debt this year, attracted by lower debt levels in many of the sector’s economies, a broad trend for rising ratings across the asset class and ultra-low rates in developed markets.
Emerging hard currency bond issuance has hit record levels, and analysts have revised up their borrowing forecasts for the year to well over $300 billion.
European Central Bank President Mario Draghi’s pledge in July to do whatever it takes to preserve the euro, followed by the promise of the ECB’s bond-buying programme, also swelled appetite for riskier emerging markets.
But the tightening in emerging sovereign debt spreads, particularly since the summer, has triggered alarm bells.
Emerging sovereign debt spreads have narrowed around 150 basis points this year to 270-290 bps over U.S. Treasuries.
That’s still well above record low levels of 150 bps hit in mid-2007, before the global financial crisis. But U.S. Treasuries offered higher yields then, giving average total yield for emerging market debt of more than 6 percent, compared with little more than 4 percent now.
Fair value for spreads is at levels tighter by only around another 20 basis point, Morgan Stanley analysts say, due to the renewed pessimism about the developed world.
“U.S. and European concerns are likely to hold back significant risk-taking as we head into year-end,” they wrote in a client note.
Emerging stocks have risen a more modest 8 percent this year, keeping pace with developed world bourses but also masking some huge gains in frontier markets, such as the 35 percent surge in African stocks.
Some equities sectors, though, are also starting to look pricey. Investors are well aware of the theme of the growing middle class in emerging markets, particularly in some of the newer markets, and this has made consumer stocks a favorite -- maybe too much of a favorite.
“Over the last two years, a lot of investors have been focusing on consumer staples which has taken the sector up to quite aggressive valuations and given very limited scope,” said Knut Harald Nilsson, portfolio manager at Skagen.
Forward price/earnings (PE) ratios stand at around 21 for the sector, compared with a 12-year average of about 15, according to DataStream.
This makes it more appealing to buy consumer stocks listed in developed markets but with emerging market exposure, Nilsson said.
So if emerging sovereign debt isn’t great and neither are some emerging equities, where else is there to go?
Investors have already rotated this year into emerging corporate or frontier debt, and even into peripheral euro zone markets.
There could be more of that to come.
Additional reporting by Joel Dimmock, Vincent Flasseur and Sujata Rao. Editing by Jeremy Gaunt.