The surge of inflows into emerging markets is a sign of things to come, according to Ashmore’s Jan Dehn, who said the sluggish pace with which government pension funds react to market inflection points means we have only just started to see the return of institutional money to the sector.
Templeton Emerging Markets Group noted earlier this month that the sector recorded inflows of $80bn in 2017, compared with minor inflows in 2016 and outflows in 2013 to 2015.
Dehn, head of research at Ashmore, said his one prediction for 2018 is that the strong inflows into emerging markets will continue over the course of the year.
He noted that money started to return to the asset class in the third quarter of 2017, which he said is significant as this is 18 months since the market turned and is consistent with the amount of time it takes for institutional investors to react to such a change.
Performance of index over 5yrs
Source: FE Analytics
“For those of you who are not familiar with how the US and European pension fund systems work, especially public pension funds, they are managed by highly competent but ultimately quite poorly paid civil servants,” he explained.
“In particular, they don’t get bonuses when they get anything right, but they run a pretty big risk of getting sacked if they get anything wrong. And for this reason, they have no incentive to take risk.
“It’s perfectly rational to behave this way, because why shouldn’t you?”
Of course, this risk-averse culture is at odds with running a pension portfolio, as there will inevitably come a time when a major asset allocation decision needs to be made. Dehn said this has resulted in the emergence of an entire industry of consultants acting as financial intermediaries, who exist purely so that these civil servants don’t have to make this call themselves.
The head of research noted the consultants can take six to 12 months to make up their minds about whether there has been a turning point or not, “moving a little bit faster because they are private sector companies and they will reward risk-taking, unlike public sector institutions”.
“And so, six-to-12 months after the market has turned, these guys will start signalling that pension funds should now buy more emerging markets,” he continued.
“When enough of them signal this, public sector managers will then have enough justification, in case they were wrong, to say ‘they all told us to’.”
At this point, Dehn (pictured) said the civil servants will make a presentation to the board of the pension fund, recommending they buy more emerging market assets. The board will then meet “at a time of convenience to them” and decide whether or not to allocate more money to emerging markets.
If the board decides to increase the allocation, the technical staff on the pension fund will issue a request for proposal (RFP) to all asset managers, typically receiving replies from 60 of these. The proposals will be made up of 100-page documents including details such as their investment process, fee structure, staff turnover and back-office capabilities.
The staff on the pension fund will then sift through 60 or so 100-page applications in order to whittle the number down to just four, who will then be called in for a finals pitch.
“In a finals pitch, you are sitting down and you have one hour to summarise all this information and after that, they will choose two,” Dehn explained.
“These two are the ones who are lucky and who are going to get the money from the pension funds.”
However, the manager said the process is still not over.
“Before they get the money, they have to write a so-called IMA – investment management agreement.
“This is where their lawyers and the government’s lawyers sit down and write a very detailed contract explaining how they are going to relate to each other in the course of this business relationship.
“That takes three months. And only then will the Formula 1s in the big pensions space make an allocation. And it is the ’Formula 1’ guys, the fastest ones, that take 18 months to do this.”
So far, less than half of the money that was pulled out of emerging markets since the US announced the tapering of its quantitative easing programme in 2013 has made its way back. Dehn said that most of the capital that returns to emerging market debt will go into bonds priced in local currencies – where the potential for gains from undervalued currencies is much higher – which will have a snowballing effect on the economy.
“Eighty-eight per cent of Brazilian bonds, for example, are now sitting in Brazil, so if I get the inflows into local-currency bonds, I am going to have to put the money into Brazil,” he continued.
“If I put money into Brazil, yields fall, credit conditions ease and Brazilian banks will start making corporate loans. When they start making corporate loans, Brazilian companies can begin to invest again and they want to invest because their currency has dropped 50 per cent and their inflation rate is now down to 2.9 per cent, so they are very competitive.
“So as soon as they can get a credit line and buy a machine, they can pay some engineers to run the machine, these guys will get a salary, they can now go to the bank and get a credit line and buy school clothes for their kids or whatever.”
“The point I am making here is that inflows into local markets create a stimulus to domestic demand.”
This is significant as domestic demand accounts for 75 per cent of GDP in emerging markets on average, and exports only 25 per cent.
While growth in emerging markets is expected to outperform that in developed markets over the next five years, Dehn thinks the actual number will still surprise to the upside as he is sceptical that the IMF and World Bank have factored in the impact of capital inflows into their GDP forecasts.
“The last time I worked in those institutions, I noticed that they were all very risk-averse and regarded themselves as the world’s insurance companies.
“They would absolutely not go out and make bold predictions about inflows, because ‘surely those can’t be predicted’,” he explained.
“Well in that case these growth predictions are all because of exports, but I think that domestic demand is going to cause this growth rate to surprise to the upside.
“In fact, I would go so far as to say that since many Asian economies are already close to full employment, that it will be quite possible that it will be emerging markets, not the Fed, that will lead the world rate-hiking cycle.”