IMF warns one of most crowded bond trades near tipping point

[MOSCOW] It's one of the most crowded trades for good reason. But dizzying returns and a surge of inflows have put emerging markets on a narrow precipice.

After several false starts, economists are predicting next year will finally be the one in which borrowing costs get a significant leg-up. The International Monetary Fund is warning it could mark the tipping point for emerging-market bond funds sitting on the biggest annual inflows since the financial crisis.

"It's an increasingly uncomfortable equilibrium," Societe Generale SA strategists including Jason Daw said in a December report. "Eventually, there will be a Minsky moment that will impair parts of the EM complex." Investors piled into emerging-market bond funds this year as central banks delayed curbing monetary stimulus that's pumped liquidity to developing economies over the past decade. A pickup in global growth that pulled Russia, Argentina and Brazil out of recession also helped to buoy sentiment, driving returns of 19 per cent since the end of 2015 versus 12 per cent in the period for a global credit index.

Monetary policy normalization will reduce inflows to emerging-market funds by US$70 billion over the next two years, according to IMF estimates published in a report by economist Robin Koepke last week. The guardian of financial stability warned diminished access to foreign capital could also make it more challenging for economies in the developing world to finance deficits and roll over debt.

Just over half, or US$1.2 trillion, of the total external debt stock owed by emerging-market issuers comes due through 2022, according to Bloomberg Intelligence data.

But even if they have to refinance at higher rates, companies in the developing world shouldn't become less able to service their debt given rebounding corporate revenues, said Sacha Tihanyi, senior emerging-market strategist at TD Securities LLC in New York.  "So long as higher funding costs come from economic growth and a Fed hiking rates for positive reasons, there'll likely be an offset," Tihanyi said. "I wouldn't be overly concerned in general about emerging-market corporates having trouble refinancing or servicing hard-currency debts." Stress tests conducted by economists at the Federal Reserve for a June study found that emerging-market companies are less reliant on hard-currency borrowing than in previous financial crises, and the risk posed by currency mismatches is less acute.

Still, emerging markets ranked in the top 5 most-crowded global trades based on long positions in a Bank of America Merrill Lynch fund survey published on Dec 19. A gradual pace of monetary normalization is "crucial" to ensuring emerging markets' ability to adjust to reduced inflows, according to the IMF's Koepke.  Borrowing costs across advanced economies are expected to climb to at least 1 per cent next year in what would be the largest increase since 2006, while the European Central Bank curtails bond buying and the Fed downsizes its balance sheet.

"Even limited withdrawals of foreign capital could result in significant stress on emerging market borrowers if they were to occur over a relatively short period," Mr Koepke said.

BLOOMBERG