Emerging market bond bubble will burst soon.

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Emerging market bond bubble will burst, financial advisers fear.

Financial advisers fear a crash could come soon as income-seeking investors flood into emerging market bond funds, despite warnings from the Bank of England that this may be a bubble about to burst.

By Ian Cowie 7:45AM GMT 20 Dec 2010

All eyes on China.

Unit trusts investing in Brazil, Russia, India and China, sometimes called the BRIC countries, and other high growth economies are attracting record inflows, according to the Investment Management Association.

Emerging market bond funds – investing in IOUs issued by BRIC governments and large companies - offer higher yields than equity or share-based emerging market funds. While Bank of England base rate remain frozen at 0.5 per cent and the yield on the FTSE 100 index of Britain’s biggest companies shares hovers around 3 per cent, some emerging market bond funds yield 6 per cent.

Only four unit trusts have a five year track record in this sector – those run by Threadneedle, M&G, Schroder and Invesco – but they have all delivered total returns of more than 50 per cent over the period, compared to less than 23 per cent from the FTSE 100. But the past is not a guide to the future and these funds do not guarantee investors’ income or capital.

The Bank of England highlighted five keys risks facing the British economy in its latest bi-annual Financial Stability Report. It said these included investors seeking better returns than they can get on deposit by investing in emerging markets. The Bank explained that too much capital flowing into these economies could lead to unsustainable bubbles which could destroy investors’ capital if they burst.

Leading independent financial advisers (IFAs) agree.

Mark Dampier of Hargreaves Lansdown said: “The best time to buy emerging market bonds was during the Russian default crisis in 1998 - but did anyone do so? Of course not.

“Fast forward to now and the whole world wants them. The party is in full swing and could be fun for a little longer. Yes, we all know we have the debt and they have the cash; lending money to people who can pay it back is an excellent principle.

“But inflation is rising in most emerging markets and interest rates are going to rise further. This is surely not the best background for fixed interest bonds. In addition the flood of money is causing some governments to bring in currency controls and taxes. So my view is that investors should be very careful, as this party could end with a big hangover.”

Ben Willis of Whitechurch Securities agreed. He said: “We sold our positions in emerging market bond funds, taking profits, in July this year. Our main reason for this was that yield premiums between emerging markets’ and developed countries’ debt – or the bonds issued by governments and large companies - had narrowed significantly and capital prices had appreciated.

“When we invested in this sector we obtained a running yield of about 7 per cent but it had fallen to nearer 5 per cent, because prices had risen, by the time we sold. Furthermore, many emerging market countries have taken measures to stop their economies and currencies from expanding further - most notably Brazil, which imposes a foreign investment tax on its fixed income securities.”

But there are wide variations between emerging market bond funds and some advisers claim this high yield sector could continue to enjoy outstanding total returns. See analysis today for specific fund tips.

 

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Sovereign default by China ?
The Telegraph.uk

China's credit bubble on borrowed time as inflation bites

The Royal Bank of Scotland has advised clients to take out protection against the risk of a sovereign default by China as one of its top trade trades for 2011. This is a new twist.


By Ambrose Evans-Pritchard 6:43PM GMT 15 Dec 2010

It warns that the Communist Party will have to puncture the credit bubble before inflation reaches levels that threaten social stability. This in turn may open a can of worms.

"Many see China’s monetary tightening as a pre-emptive tap on the brakes, a warning shot across the proverbial economic bows. We see it as a potentially more malevolent reactive day of reckoning," said Tim Ash, the bank’s emerging markets chief.

Officially, inflation was 4.4pc in October, and may reach 5pc in November, but it is to hard find anybody in China who believes it is that low. Vegetables have risen 20pc in a month.

The Communist Party learned from Tiananmen in 1989 how surging prices can seed dissent. "Inflation is a redistributive mechanism in favour of the few that can protect living standards, against the large majority who cannot. The political leadership cannot, will not, take risks in that regard," said Mr Ash.

RBS recommends credit default swaps on China’s five-year debt.
This is not a forecast that China will default. It is insurance against the "fat tail risk" of a hard landing, with ramifications across Asia.

The Politburo said on Friday that China would move from "relatively loose" money to a "prudent" policy next year, a recognition that credit rationing, price controls, and other forms of Medieval restraint are not enough. The question is whether Beijing has already left it too late.

Diana Choyleva from Lombard Street Research said the money supply rose at a 40pc rate in 2009 and the first half of 2010 as Beijing stoked an epic credit boom to keep uber-growth alive, but the costs of this policy now outweigh the benefits.

The economy is entering the ugly quadrant of cycle – stagflation – where credit-pumping leaks into speculation and price spirals, even as growth slows. Citigroup’s Minggao Shen said it now takes a rise of ¥1.84 in the M2 money supply to generate just one yuan of GDP growth, up from ¥1.30 earlier this decade.

The froth is going into property. Experts argue heatedly over whether or not China has managed to outdo America’s subprime bubble, or even match the Tokyo frenzy of late 1980s. The IMF straddles the two.

It concluded in a report last week that there was no nationwide bubble but that home prices in Shenzen, Shanghai, Beijing, and Nanjing seem "increasingly disconnected from fundamentals".

Prices are 22 times disposable income in Beijing, and 18 times in Shenzen, compared to eight in Tokyo.

The US bubble peaked at 6.4 and has since dropped 4.7. The price-to-rent ratio in China’s eastern cities has risen by over 200pc since 2004

 

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The result of such a hard landing would be a 20pc fall in global commodity prices, a 100 basis point widening of spreads on emerging market debt, a 25pc fall in Asian bourses, a fall in the growth in emerging Asia by 2.6 percentage points, with a risk that toxic politics could make matters much worse.

Albert Edwards from Societe General said the OECD’s leading indicators are signalling a "downturn" for Asia’s big five (Japan, Korea, China, India, and Indonesia). The China indicator composed by Beijing’s National Bureau of Statistics has fallen almost as far as it did at the onset of the 2008 crash.

"I remain convinced we are witnessing a bubble of epic proportions which will burst – catching investors as unawares as the bursting of the Asian bubbles of the mid-1990s. Ignore these indicators at your peril," he said

In a sense, inflation is a crude way of curbing China’s export surpluses and therefore of resolving a key trade imbalance that lay behind the global credit crisis.

If China continues to stoke inflation – and blaming the US Federal Reserve for its own errors help – there will no longer be any need for a yuan revaluation against the dollar, and the US Congress can shelve its sanctions law.

China may have hit the "Lewis turning point", named after the Nobel economist Arthur Lewis from St Lucia.

It is the moment for each catch-up economy when the supply of cheap labour from the countryside dries up, leading to a surge in industrial wages. That reserve army of 120m Chinese migrants everybody was so worried about four years ago has already dwindled to 25m.

China’s problem is that this is happening just as the aging crisis starts to bite. The number of workers will decline in absolute terms within four years. The society will then tip into precipitous demographic decline.

Unlike Japan, it will become old before it is has built a cushion of wealth.

If there is a hard-landing in 2011, China’s reserves of $2.6 trillion – or over $3 trillion if counted fully – will not help much. Professor Michael Pettis from Beijing University says the money cannot be used internally in the economy.

While this fund does offer China external protection, Mr Pettis notes wryly that the only other times in the last century when one country accumulated reserves equal to 5pc to 6pc of global GDP was US in the 1920s, and Japan in the 1980s.

We know how both episodes ended.