Yellen's Emerging Markets Bear Trap
Be on the lookout for a quick run-up in the prices of emerging-market assets, courtesy of Janet Yellen. Bears, not bulls, will drive this rally, though. Much of the gains will be triggered by investors paring bets against developing nations.
The March fund manager survey of Bank of America Merrill Lynch concluded that the three most crowded trades were shorting emerging markets and oil while betting on a stronger dollar. All three are now in danger and anyone who still is in that position will probably try to get out while they can. The survey's answers were received in early March, so the 13 percent rally this month in Brent futures, the 2.5 percent drop in the trade-weighted dollar basket and the 8.7 percent gain in the MSCI Emerging Markets stock index may be partly explained by a reversal of these trades.
Given that bond traders were pricing in a more hawkish Federal Reserve stance, any shorts left out there will be running for cover now that the U.S. central bank has scaled back forecasts for higher interest rates. That could mean another leg up, especially for emerging market assets, which benefit doubly from a weaker dollar and rising commodity prices.
Adding fuel to the fire are the high cash balances held by funds as of March. On average, funds had 5.1 percent of their assets in cash, down from 5.6 percent in February but still higher than usual, according to the Merrill Lynch survey. With the end of the quarter approaching, portfolio managers will be hard pressed to catch the rally in time to show positive performance for the reporting period. They can't afford to sit on cash which, in some markets, earns negative interest rates.
So while it may be full power ahead and risk on today, that's simply because Fed Chair Yellen's dovish tone has forced a reassessment of bearish expectations. Whether this will translate into a sustainable bull market for emerging-market assets isn't clear. Some analysts have started to argue that the asset class is cheap and too under-weighted after what has effectively been a five-year bear market punctuated by the occasional rally.
The MSCI Emerging Markets index is down 33 percent from the high it touched on May 2, 2011. It's also 16 percent below the average of the past 10 years. That decade, however includes the bubbly 2007-2008 period leading to the global financial crisis, so the average could be skewed. At a trailing price-to-earnings ratio of 12.8 and a forward P/E of 12 times, the index's value metrics are in line with historical levels and not necessarily cheap.
Growth is slowing across the developing world, led by China. Not to mention that leverage is nearing its limits. Meanwhile, if Yellen can afford to be so tranquil about future inflation, it means the U.S. economy isn't expanding at a runaway pace. A slowing U.S., the main growth engine for the world economy, is hardly bullish for emerging-market stocks.
Investors should keep in mind that near-term gains don't always translate into long-term profits.
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