30-Year EM Veteran Fears "The Most Illiquid Market Conditions I've Ever Seen"

Low market volatility spurred a “torrent” of capital flows into emerging-market debt, reflecting investor complacency and “excessive risk taking,” Bank of America Merrill Lynch strategists led by David Hauner in London wrote in a report last week. He warned that the second half of the year should bring challenges for lower-rated issuers as higher interest rates in the U.S. reduce some of the appeal of junk credits with relatively steep interest rates.

“The market is at a point where we haven’t hit a real bump in the road to wake everyone up.”

And they are not alone. Since entering the world of emerging markets nearly three decades ago, Robert Koenigsberger, who oversees $6 billion as chief investment officer at Greenwich, Connecticut-based Gramercy Funds Management, has seen more than his share of changes. One of the most consequential, BloombergQuint.com reports, is the migration of allocators from hedge funds to exchange-traded and mutual funds in recent years.

That’s effectively made ETFs one-day liquidity vehicles, versus the 90-day instruments leveraged funds typically offer, which, as Koenigsberger explains simply means:

"This market isn’t well set up for outflows."

Which is a big problem, because, outflows are accelerating...

As JPMorgan recently noted...

What caused this deterioration in EM overall capital flows in Q2? It is difficult to answer this question given that current account data are not available for Q2 for most EM countries. But if one uses high frequency data of fund flows such as equity and bond ETF flows as proxies for overall portfolio flows, we find portfolio flows were not responsible for the deterioration in the overall EM capital flow picture in Q2. Both EM equity and EM bond fund flows were rather strong in Q2 and if anything there was acceleration in EM equity fund flows relative to Q1.

As a reminder, in the run-up to this dumping of EM assets, expected uncertainty in Emerging Market Equities has never been lower... (in fact EEM implied vol is now less than half its lifetime average of 29.7%)


What was even more stunning than investors' tolerance for these risky issuers is how little compensation they’re demanding in return.  Emerging Market bonds were pricing in the least 'risk' since Dec 2007...

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