The International Monetary Fund (IMF) has now said what many of us in India had suspected all along. Its latest Global Financial Stability Report says: “The policy measures adopted in many countries have yet to address the overarching issue of a secular asset allocation shift from developed markets to assets in emerging economies.” IMF is telling us there has been a “secular” shift in asset allocation. It’s not a cyclical shift, it’s not caused by temporary conditions prevailing today in the aftermath of the financial crisis—rather, it’s a long-term trend that will be sustained.
IMF is saying here that fund flows to emerging markets will continue to be very strong in the long run. It says that institutional investors are in the process of making a shift in asset allocations from developed to emerging markets. The process started in 2003 and flows to emerging markets have nearly quadrupled since then. The record net fund inflow from foreign institutional investors to the Indian stock market is part of this process. Nor is it just institutional investors that are putting their money in emerging markets—retail investors in the developed world are also not far behind, as seen from the rise in the assets of exchange-traded funds dedicated to emerging markets. Retail fund flows to emerging markets have outperformed flows to mature markets since the start of the global crisis.
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But why does IMF say this is a long-term trend? That’s because institutional investors’ allocation to emerging markets is much lower than the proportion of emerging markets in world market capitalization. This column had some time ago pointed to a Goldman Sachs paper on the subject. Research by MSCI Barra in October last year (Globalization of Equity Policy Portfolios by R.A. Subramanian, F. Nielsen and G. Fachinotti) had drawn attention to declining “home bias”, which is a bias in asset allocation where investors put more money in the home market. The paper said that the proportion allocated to US stocks in the top 200 US pension funds had fallen from 73.7% in 2004 to 66.8% in 2008. But that proportion is still far more of US market cap as a proportion of total market cap. The paper also said that a number of large and leading US pension plans have recently started considering Global Equity as a single asset class, which would mean their allocations to different equity markets would be on the basis of a global benchmark such as the MSCI All Country World index, in proportion to their market capitalization. Another paper by MSCI Barra that considered European asset allocation said much the same thing.
What will be the impact of this reallocation of assets? According to IMF, in 2009 the proportion of emerging market equities to world market cap was 15.9%. The share of emerging equities in US investors’ portfolios, however, was just 2.4%. So there’s plenty of scope for reallocation. Here’s what the IMF report says: “Total emerging market assets only account for around 2-7% of real money portfolios currently. A 1 percentage point reallocation of global equity and debt securities held by G-4 real money investors, which amounts to about $50 trillion, would result in additional portfolio flows of $485 billion. This would be larger than the record annual portfolio flows to emerging markets of $424 billion recorded in 2007.” In short, if IMF has got it right, there could well be a tsunami of fund flows to emerging markets.
There are other reasons for a reallocation of assets. One of them, of course, is the much higher growth in emerging markets and the improvement in their finances. This has led to 21 rating upgrades for emerging market sovereigns since early 2008, while developed country sovereigns have seen 25 downgrades. That has led to funds flowing into emerging market local currency bonds, a trend also supported by very low interest rates in developed markets. So despite the possibility of slower growth going ahead, funds flows to emerging economies should remain strong. Add to that the fact that, according to a note on Asia strategy by Macquarie Research, MSCI Asia ex-Japan 12-month earnings yield at 8% offers a premium of 5.5 percentage points over US treasury for those willing to bear the equity risk. And that’s not counting the gain from appreciation of the Asian currencies.
All these factors have led the Institute for International Finance (IIF), a global association of financial institutions, to increase its projections for fund flows to emerging markets this year. It estimates that net portfolio investment in equities is likely to be $187 billion against $149 billion in 2009. Portfolio flows to Asian equities are estimated at $93 billion against $86 billion last year. Interestingly, though, these flows are expected to moderate substantially in 2011.
Both IMF and IIF predict that the huge inflows will lead to headaches for policymakers in emerging economies, because of the pressures on exchange rates, while measures taken to limit appreciation could lead to inflation. IMF also warns that there is often herding behaviour among investors and warns that this could lead to deep sell-offs should the flows reverse.
But while there will certainly be sell-offs, the higher weight to emerging markets in asset portfolios that IMF talks about will mean that emerging equities should be rerated, leading to higher price-earnings multiples than were the norm earlier.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org