Global trade risks threaten emerging markets after worst quarter since 2015

● A dark quarter for emerging-market bulls is nearing an end, and it’s not clear whether things will get much brighter down the road, especially in the near term.

Currencies, stocks and bonds in developing countries are closing out their worst quarter since 2015 and facing a looming trade war, tightening US monetary policy, elections in Latin America and a weaker global growth outlook. Valuations may look appealing, but this thicket of risks has some investors cautious about plunging back in.

The consensus is that, whether emerging markets are set for a rebound or a deeper sell-off, in the short term the asset class is at the mercy of trade headlines.

Goldman Sachs, Morgan Stanley and Citigroup have warned in recent days that more pain lies ahead thanks to the tit-for-tat tariffs between the US and China. And even those on the bullish side are waiting for trade rancour to die down before fully jumping in.

“From a valuation standpoint, there are attractive values. But on a tactical basis, we think there may be more pain in the next few weeks,” said Alessio de Longis, a portfolio manager at Oppenheimer Funds in New York. He also said the concern over market-unfriendly candidates winning elections in Mexico and Brazil as well as typical risk aversion during summer in the northern hemisphere could put pressure on emerging-market currencies in the coming months.

What looked like a moderate downturn earlier this year turned into a fully fledged plunge in the second quarter. The MSCI benchmark index for stocks has fallen about 11%, currencies have dropped almost 6% and the spread on hard-currency sovereign bonds has widened by 66 basis points.

These are the worst quarterly results since September 2015, when developingcountry assets were in free-fall following a meltdown in Chinese stocks and an unexpected devaluation of the yuan.

The stark result stands in contrast to the common refrain about the relative health of emerging markets. Few investors predicted a repeat of the rally in 2017, but many cited maturing financial markets and reformed political systems as reasons to remain optimistic about a sector that now accounts for about 70% of global gross domestic product.

Local-currency bonds from emerging markets were also burnt, as their returns to foreign investors are automatically squeezed if the dollar strengthens. And they haven’t recovered as the dollar has continued rising.

A Barclays index for local-currency bonds from developing countries has fallen 6% this quarter, more than erasing the 3% gain of the first quarter.

Outflows have hit almost all markets and were recently a highlight in South Africa as foreign investors rushed to sell local bonds, draining their holdings to the lowest level in more than a year, as the rand slumped and the country seemed vulnerable to a more sour external backdrop.

The rand traded slightly better on Friday afternoon at R13.81 to the dollar, but remained on pace for its biggest quarterly drop since 2011, having lost 17% of its value against the dollar. For the most part, external drivers affecting the rand, including trade war concerns and the prospect of higher interest rates in the US, have hurt the currency, as shown by bond outflows.

Gordon Kerr, a fixed-income specialist at RMB, said: “I am still bullish in terms of the outlook for the rand and the outlook for the dollar r and. If we can get some downward momentum in the dollar, the 14 level becomes harder to achieve.”

Elsewhere the currency depreciation that hammered bonds triggered central bank responses in many emerging markets. “EM central banks are responding in an orthodox way,” said Timothy Ash, an emerging-market sovereign specialist at Bluebay Asset Management in London. However, “if concerns over a trade war hit global growth and then this feeds through into commodities, then we might have a proper EM bear market.”

The combined market value of 24 emerging markets tracked by MSCI has fallen by more than $2-trillion this year. Morgan Stanley strategists lowered their 12-month target for the MSCI emerging-markets index to 1 000 from 1 160 and cut their equity allocation to add cash. Investors in exchange-traded funds also turned pessimistic. Withdrawals from the iShares MSCI Emerging Markets ETF exceeded $5-trillion in the second quarter, rivalling levels seen during the eurozone debt crisis and the winding down of US Federal Reserve stimulus in 2014.

As cash investors run for the exits, short sellers are moving in for the kill. They have added more than $1.8-trillion of bets in the past three weeks, wagering that emergingmarket stocks will keep dropping.

— Bloomberg and Asha Speckman

There are attractive values but there may be more pain ahead