These 5 shocks could thwart 2-year EM rally

Plenty of things could upend the two-year rally in emerging-market equities. Yet, no one seems to agree on just what they are. Of course, the bulls abound. Fiera Capital Corp, the Montreal money manager that oversees $123 billion, expects attractive returns for several more years. Research Affiliates, a subadviser to such firms as Pacific Investment Management Co, calls emerging markets the “trade of a decade.”

Yet, contrarians are sounding the alarm, with Morgan Stanley the latest, saying that emerging equities may see a repeat of the year 2000, which began well and ended with a 32 per cent drop. Here are five potential causes for concern:

Tech downturn

To UBS's Bhanu Baweja, normal warning signs such as an inflection in the growth cycle, expensive valuations or declining oil prices aren’t visible. The bigger risk could be a downturn in the burgeoning technology sector, according to Baweja, the London-based head of emerging-market cross-asset strategy. He’s “skeptical” emergingmarket technology firms will replicate last year’s revenue. Hardware companies may be particularly susceptible as memory demand falls. A selloff in bitcoin could also hamper the industry, he said.

Baweja’s base case remains 10 per cent returns in 2018, down from last year’s 38 per cent rally. He expects growth and returns to slow by the end of the year.

Stronger dollar

Jeff Gundlach, chief investment officer at Los Angelesbased DoubleLine Capital LP, says a near-term rally in the dollar and valuations at nearrecord levels will probably prove a temporary setback for developing-nation stocks.

“It’s not a great time to be buying emerging markets because the price point is pretty bad,” the billionaire bond manager said during his annual “Just Markets” webcast last week. “he trade location is pretty bad — you’re up where it reversed before.”

Still, Gundlach said developing nations present an attractive option for “years to come” for longer-term investors. He cites the Shiller P/E Ratio, a measure of valuation based on cyclically adjusted price-to-earnings ratio, which shows investors paying a premium for US stocks compared to emerging-market equities. Research Affiliates has made the same argument as it projects outsized returns for emerging markets.

Economic slowdown London-based consultant Capital Economics expects emerging-market economic growth to slow to 4.2 per cent in 2018 from 4.4 per cent last year.

Much of the deceleration is due to China, where the slowdown could undercut industrial commodity prices. As a result, the rally in developingnation stocks will probably “fizzle out” and the MSCI Emerging Market Index will end the year “slightly lower” on a dollar basis, the firm said last week. The Capital Economics prognosis for 2019 is even worse: 4 per cent growth. Prices will “fall sharply in 2019 as the US stock market tumbles.”

Overbought stocks Goldman Sachs Group Inc says records for global stocks imply a higher risk for a market retreat. The firm notes that the MSCI Emerging Market Index is on its longest-ever streak without a 10 per cent correction. “So far this year, risk appetite has picked up materially, nearing its all-time high, led by equities,” Goldman analysts including Ian Wright said in a note. Still, it's unlikely that losses extend into bear territory, according to the strategists, who remain overweight on emerging-market equities.

Inflation spike

An unexpected sharp spike in inflation within mature markets could be “a game-changer” for emerging-market equity flows, according to Emre Tiftik, the deputy director of global capital markets at Washingtonbased Institute of International Finance. Although not his base case, it would probably spur tighter global financial conditions, potentially reducing dollar liquidity and adversely affecting developing-nation stocks. Tiftik says the IIF remains constructive on emerging markets for now and forecasts non-resident portfolio equity flows rising to more than $150 billion this year from $70 billion in 2017.