Leading Hedge Fund Warns Of Violent Emerging Market Selloff

The hedge fund that outperformed 99% of its rivals last year by taking a pessimistic position on developing markets believes the selloff since February has proven its pessimism correct and that risky assets would suffer even greater losses later this year.

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Man Group Plc, the world's largest publicly traded hedge fund, told Bloomberg in February that the October-January rise in developing markets was unjustified by economic fundamentals and was destined to reverse. Soon later, the forecast came true, with sovereign dollar bonds from emerging nations losing 2.2% and the benchmark MSCI emerging-markets equities index plunging nearly 7%.

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"Our argument is still pretty much in play," said Guillermo Osses, the firm's New York-based head of emerging-market debt strategy. "We are in one of the most defensive positions we have ever had."

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Osses explained that transitory rallies earlier this year were just a result of dollar liquidity dynamics as regulators worked to mitigate the fallout from Silicon Valley Bank's failure. His pessimism contrasts with the recommendations of major Wall Street businesses such as BlackRock Inc., Goldman Sachs Group Inc., and the asset-management arms of Morgan Stanley and JPMorgan Chase & Co. to spend more money in developing economies.

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So far this year, the reopening of China's economy, a weaker currency, and lower global inflation predictions haven't translated into the types of returns that bullish emerging-market debt and equity investors expected. This year, the MSCI Emerging Markets Index has outperformed the S&P 500 by 1.5% and 5.6%, respectively.

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Man Group's pessimism hasn't worked either. According to Bloomberg statistics, its emerging-market debt fund has lost 1% this year and has been outperformed by nine of ten rivals. Osses, citing corporate policy, declined to comment on fund results.

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However, he reiterated his belief that changes in the emerging-market bond spread, currencies, and rates have been primarily driven by US liquidity rather than changes in developing countries' macroeconomic outlook.

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Liquidity Drain

The next six to nine months will be markedly different, according to Osses, who predicts a massive liquidity drain as the Federal Reserve tightens monetary policy and the US Treasury's cash balance rises — something that should occur if and when the debt-ceiling impasse is finally resolved. 

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Along with boosting interest rates, the Fed has been trying over the last year to shrink its balance sheet by allowing some of its maturing bond holdings to roll off, a process known as quantitative tightening. This year's increase in emergency lending to banks reversed some of the balance-sheet shrinkages, but the effect is fading as facility use declines. 

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Meanwhile, the Fed's bond holdings are shrinking by approximately $95 billion per month. If the central bank continues to tighten, that corresponds to about $1.1 trillion in annual tightening, which it could achieve even if it stops raising interest rates. According to Osses, the damage will be exacerbated by a comeback in the Treasury cash balance following the ultimate achievement of a debt-cap solution.

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Risk Assets

Bond spreads in developing economies would expand as a result, he predicts, "much more violently than the one we saw in early 2022," when Russia invaded Ukraine. According to a Bloomberg index that tracks corporate and sovereign dollar bonds, emerging-market debt fell 15% that year, the most since at least 1994.

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"From a risk-reward standpoint, it's very difficult to have significant exposures in the next six to nine months because everything is going to play against risk assets," Osses said. 

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A further hurdle is offered by Japan's central bank, which may ease its government bond yield control, lowering demand for emerging-market debt from the country's institutional investors, he added.

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Market indicators in troubled nations in Africa, the Middle East, and South Asia are illustrative of the dangers confronting emerging-market investors since lower-quality debts have already been blocked off from international borrowing markets, and prices reflect this, according to Osses.

"As this liquidity drain deepens, the situation will become more difficult," he added, especially for developing-country policymakers who continue to function as if the liquidity they've been accustomed to in recent years will be accessible. "We believe they haven't yet realized that this is about to change dramatically and that it is already changing."

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