Emerging market bears speaking up
LONDON: Sceptics about the relentless emerging-market rally are speaking out at last. A drop in oil prices and China’s crackdown on leverage — spurring this month’s rout in industrial metals and iron ore — is setting the stage for a correction in developing-country assets, according to a growing chorus of investors and analysts.
While still in the minority, they warn that a tide of capital inflows and a jump in bullish positions have left valuations at inflated levels after gains in emerging-market stocks, bonds and currencies this year.
Global markets have largely shrugged off Beijing’s move to tighten credit — which has sparked a rout in domestic stocks and bonds — driven by rosy projections for output, the exchange rate and capital account. China’s 10-year government bond yield will peak at 3.8% by June before moderating, according to a Bloomberg survey. But bears say investors are discounting the risk that the reduction in leverage will slow growth in other developing nations as well.
“Sell the strength,” said Arthur Budaghyan, a strategist at Montrealbased BCA Research Inc. “When the rally cracks in the weeks ahead, investors should establish short positions because the potential downside will be considerable.”
The premium on emerging-market sovereign debt over US Treasuries has tumbled over the past month, while inflows to equity and bond funds have gathered steam. Investors put more than $2.5 billion into emerging-market bond funds in the week to May 3, a 14th week of net gains, according to the consultancy EPFR Global, while equity funds took in $2.4 billion, the seventh consecutive week of inflows.
“Flows have been rotating out of US high-yield debt and into emerging markets, which has papered over the vulnerability of emerging markets to higher rates, a stronger dollar and weaker commodities,” said Ed Al-Hussainy of Columbia Threadneedle Investment.
For now, bulls are firmly in charge. The iShares MSCI Emerging Markets fund has returned 16% this year. Bulls are effectively betting on stability in China, since more than a quarter of the fund is weighted to either Chinese- or Hong Kong-domiciled companies.
From South Africa to Chile, currencies of resource-rich nations are ignoring weak commodity prices, as implied by weak 30-day correlations. That’s a sign, for some, of investor complacency. Equity investors also appear indifferent to commodity-price risks.
To be sure, technical factors also account, in part, for recent weakness in commodity prices, current-account positions among the “fragile five” bloc — Turkey, Brazil, India, South Africa and Indonesia — are strengthening, and investors are banking on relative stability in China ahead of the Communist Party’s leadership gathering this fall. But, at some point, markets may have to price in the risks to the emerging market business cycle posed from China.