An emerging market selloff has reached a tipping point.
Record outflows from bond funds in emerging markets last week revealed how close investors could be to capitulation, ready to abandon the world's few remaining pockets of growth and yield in order to seek refuge in absolute safety.
Thus far it has been orderly. Stock markets and currencies in emerging Asia, Europe and Latin America have been falling since August. Yet it's largely been speculative short-term players who are fleeing emerging market assets rather than fund managers and retail investors.
Last week's massive bond selloff has been a rude reminder that the markets are now treading a fine line between prudence and panic, and that piles of foreign cash have come into emerging markets since Lehman Brothers collapsed in 2008.
Also coming clear is that real money investors who extrapolated a 2008-like scenario of a quick market bounce-back into this crisis could now succumb to a chain reaction of redemptions, stop-losses and broader despair about the state of the world economy.
There are risks compared to 2008 driven by lower absolute yields as well as higher foreign ownership in the local currency debt, said Neeraj Seth, head of Asian credit at BlackRock. Hence I would be cautious in the short term but would remain constructive in the mid- to long term.
BlackRock manages $1.2 trillion in fixed income assets globally. Seth says investors are not losing faith in emerging market assets, notwithstanding the volatility, and that this selloff wouldn't be a re-run of 2008.
Joep Huntjens, head of Asian credit investment at ING Investment Management in Singapore, also sees little risk. He said institutional clients are still stocking up on emerging market bonds, even if outflows and volatility persist for a while.
Somewhat worryingly though, there was no apparent trigger for the sudden rise in market anxiety last week. Asian stocks are at a 16-month low, but they have been falling since May.
But it's also true that any hope Europe will fix its debt crisis, prop up its banks and avert a disorderly debt default by Greece is fast evaporating.
Furthermore, the risk of a global crisis of confidence has grown, as has the probability the U.S. economy stalls for some time, not to mention the flare-up in concern that China's property bubble could burst.
EPFR Global, a private firm that provides asset allocation and fund flow data, estimates emerging market bond funds recorded $3.2 billion of net outflows in the final week of September, a record high.
That's just one-tenth of the inflows emerging market funds received since early 2009, UBS says. And a lot more money would have gone into the more liquid and deep equity-focused funds.
EPFR estimates show emerging market equity funds have seen nine weeks of selling, to make the third quarter their worst ever since Lehman went under.
HOW BAD CAN IT GET?
Until last week, investors -- both institutional and retail -- seemed prepared to wait it out.
Asia-focused fund managers confess they have cut exposure to companies that either had heavy refinancing needs or were exporting to the developed world, but the money remained in the emerging world, a lot of it in anticipation of a post-crisis rally, just like in 2009.
People got burned during subprime not on the way down, but on the way up, said Mark Mobius, executive chairman of Templeton Emerging Markets Group, who oversees $50 billion in emerging markets funds. This time around they are a lot more cautious in exiting too quickly.
True, stock markets tumbled in August and September and currencies fell in Latin America, Asia and in parts of emerging Europe close to the epicenter of the crisis. Central banks have stepped into markets, buying their currencies and bonds. During September, Brazil's real currency fell 13 percent against the dollar, Korea's won was down 10 percent, the Polish zloty 14 percent.
Meanwhile, the cost of hedging currency and credit risk has risen sharply, proof that investors are by no means sitting idle as they wait to see how painful Greece's default might be.
To be short the Indonesian rupiah against the dollar through offshore forwards a month ahead can cost as much as 72 percent. Credit default swaps on five-year Indonesian debt blew out a full percentage point last month to about 280 basis points, close to 27-month highs but still well below the 2008 peak of over 1,200.
The MSCI Asia ex-Japan stock index fell 62 percent from a peak in October 2007 to its December 2009 nadir. It has fallen 24 percent in the past five months.
Shankar Narayanaswamy, a credit analyst at Standard Chartered Bank, reckons investors have moved from the first stage where they turn defensive and favor cash to the second, when large-scale fund redemptions cause broad declines in markets.
In the absence of a meaningful resolution mechanism for euro-area sovereigns, we could be on a verge of stage 3, where a serious crisis of confidence develops and liquidity vanishes from the system, he wrote.
The big problem, though, is that no one is exactly sure how much money lies invested in Brazilian, Indonesian and other emerging market bills, bonds and equities. EPFR's data doesn't cover the universe of mutual funds, let alone pension and insurance funds and other high net worth investors.
Foreign holdings on Mexican bonds are at a record high. As of September 13, non-Mexicans held 926 billion pesos ($66.6 billion) worth of local debt, nearly three times their peak holding in 2008. Brazil has seen massive inflows too, although a lot of that has been direct investment in companies.
'Positioning' is the emerging world's Achilles' heel, says UBS strategist Bhanu Baweja, the reasons being that capital inflows that are not direct investments are at 15-year highs and that markets are unprepared for a sustained rally in the dollar.
The dollar's rally in the past few weeks has practically wiped out all of this year's gains in emerging market local currency debt.
But yields on local currency bonds haven't moved much -- even the normally volatile Indonesian market has seen 10-year yields stay in a half point range around 7 percent for the past month -- confirming people haven't quit en masse.
According to UBS estimates, cumulative inflows into emerging market local currency debt markets since early 2009 amounted to $33 billion. That compares with $30 billion that came into emerging market equities, a far more liquid and bigger asset class than debt, between 2006 and September 2008.
Compared with that, the roughly $20 billion that left Asia in 2008 is modest.
It also means that this time, the emerging world has an enormous wall of money that potentially could leave in a hurry.
EPFR data corroborates that. In the first 9 months of 2011, emerging market fixed income funds attracted about $20 billion. They attracted $41.7 billion in the same period of 2010.