Emerging markets – is the rally over?

There has been a marked change in sentiment towards emerging markets this year, with more investors getting back in after disappointing performance last year.

But three analysts published warnings about the asset class on Monday. While not calling for an abrupt end to the rises in emerging markets stocks and bonds witnessed over the past few months, the warnings serve as a reminder that volatility can come back at any time.

One trigger for this could be the European Central Bank’s June 5 meeting.

With many expectations of monetary easing already priced in, “we could see any ECB decision upset emerging markets,” Simon Quijano-Evans, emerging markets analyst at Commerzbank, said.

This coming Thursday’s ECB meeting is “probably the most important” for emerging markets over the past year, as “second-guessing ECB plans has been one of the main drivers” for ongoing expectations of high liquidity, he added.

Commerzbank downgraded Turkish lira bonds to underweight and Brazilian real bonds to market weight, from a previous overweight weighting.

The German bank has an overweight weighting in its local currency emerging markets portfolio for the following countries: Colombia, Hungary, India and Romania.

For sovereign Eurobonds, it is overweight Chile, Colombia, Croatia, Hungary, Indonesia, Peru, Romania and Serbia.

Credit default swaps – the cost of insuring against default – have fallen for most emerging markets this year. Russia and Ukraine are the two exceptions, as tension between the two has chased away investors.

Emerging_Markets_CDS_Commerzbank

Emerging markets risk perception has generally fallen

Investor optimism for emerging markets is partly justified, as they are now less vulnerable to change in US monetary policy than they used to be, since many countries gave up on dollar pegs in favour of floating exchange rates, Neil Shearing and Daniel Martin, analysts at Capital Economics said.

EMERGING MARKETS LOCAL DEBT

Balance sheets in emerging markets have also “strengthened considerably” since the 1990s, which means these countries are not as easily thrown off course.

Capital Economics’ Risk Indicator shows economic and financial risks across the emerging world lower than on the eve of the Asian financial crisis in 1997 and the global financial crisis in 2008.

But for some economies, they pointed out, risks are building up. “Serially mismanaged” emerging markets like Venezuela look vulnerable, as well as countries that “in one way or another have been living beyond their means in recent years.”

Among these, the Capital Economics list parts of Latin America and South East Asia, as well as Turkey and South Africa.

If past crises were caused by a build-up of debt in foreign currency, now the main risk is the expansion of debt in local currency.

“We are especially concerned about the sustainability of credit growth in China, Brazil, Thailand and Turkey,” the analysts said.

The key for investors is to differentiate between emerging markets in order to take advantage of those where the outlook is brightening, they added.

For Shearing and Martin, the countries with the best prospects are South Korea, Philippines, Mexico, Poland and the Czech Republic.

CHINA STILL A RISK

Maarten-Jan Bakkum, a senior emerging market strategist at ING IM, said the strong rally – with emerging market stocks rising by around 10% since March – made him look again at his cautious growth scenario.

Investors have been optimistic on politics, he noted. They hoped that this year’s elections in India, Indonesia and Brazil would be won by pro-reformists, and this would break the negative policy trend and boost growth.

“So far, this optimism has only been confirmed by a positive election result in India. For the other two countries, investors are still hoping. It is therefore too soon to assume a new, positive policy trend in the emerging world,” Bakkum said in a statement.

For him, the biggest cloud on the emerging markets horizon remains China, despite the stronger than expected flash PMI number released at the weekend.

The most recent data point to a strong correction in the Chinese housing market, which in turn puts further pressure on economic growth, heightening the risk of a systemic crisis, according to Bakkum.

“All in all, the prospects for the Chinese economy are starting to look increasingly gloomy. In view of the great importance of Chinese demand for the entire emerging world, this remains the most important reason for not being too enthusiastic about the recent rally in emerging stock markets,” he said.

@AntoniaOprita