This Is What Can Kill the Emerging Market Rally

  • As bonds, stock and currencies rally, some see overheating
  • DoubleLine is latest firm to make bullish emerging-market call

Goldman's Patel Sees Investors Looking at Latin America

Dissenters in the face of the relentless emerging-market rally are speaking out.

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 a tide of capital inflows and a jump in bullish positions have left valuations at an inflated level after gains in emerging-market stocks, bonds and currencies this year.

Global markets have largely shrugged off Beijing’s move to tighten the credit spigot -- which has sparked a rout in domestic stocks and bonds -- driven by sanguine projections over the outlook for China’s output, exchange rate and capital account. China’s 10-year government bond yield will peak at 3.8 percent by the end of June before moderating, according to a Bloomberg survey. But bears say that 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 Montreal-based BCA Research Inc. "When the rally cracks in the weeks ahead, investors should establish short positions because the potential downside will be considerable."

The extra yield investors demand to hold emerging-market sovereign debt instead of Treasuries has tumbled over the past month, while inflows to equity and bond funds have gathered steam. Investors put more than $2.5 billion in emerging-market bond funds in the week to May 3, a 14th week of net gains, according to consultancy EPFR Global, while equity funds took in $2.4 billion last week, the seventh consecutive week of inflows.

"Flows have been rotating out of U.S. 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, a senior analyst on Columbia Threadneedle Investment’s global rates and currency team.

For now, bulls are firmly in charge. On Monday, DoubleLine Capital’s Jeffrey Gundlach was the latest investor to tout the trade, with a call to short the S&P 500 Index and go long the iShares MSCI Emerging Markets exchange-traded fund, which has returned 16 percent this year. The bullish positioning is effectively a bet on stability in China: Over a quarter of the benchmark EM ETF is weighted to either Chinese-domiciled companies or those based in Hong Kong, according to Bespoke Investment Group.

From South Africa to Chile, currencies of resource-rich nations are snubbing weak commodity prices, as implied by weak 30-day correlations. That’s a sign, for some, of investor complacency. Only Russia’s ruble has experienced an uptick in its ties to oil, notching a four-month high of 0.53. A correlation of 1 suggests assets are moving perfectly in lock step.

Equity investors are also expressing pronounced apathy over commodity-price risks. The four-month performance of emerging-market equities, adjusted for volatility, relative to commodities is near record highs. And investors’ overweight positions are at the highest level in five years, according to Bank of America Corp.’s monthly survey of fund managers. Strategists at the U.S. bank recommend investors snap up put options as cheap bets on an uptick in developing-country stock volatility.

Bank of America Corp.

"EM will temporarily struggle with the twin drag of lower commodity prices and China deleveraging policy," says Koon Chow, a strategist at Union Bancaire Privee Ubp SA in London. 

A stronger selloff in commodities could also be the catalyst to undo the emerging-market momentum. If the Bloomberg Commodity Index hits a key technical level of 81.9555, less than 1 percent from current levels, it could quickly tumble as much as 9 percent more, spurred by softer data from China, according to Rabobank emerging-markets currency strategist Piotr Matys.

"A break below this key trendline support could unleash carnage," he said.

Al-Hussainy reckons high interest rates in Brazil and Russia still offer investors compensation for currency risk, and is underweight debt issued by single-B and C-rated sovereigns after a six-month rally. UBS Group AG prefers Asian markets over eastern Europe, the Middle East and Africa, and local-currency bonds on a currency-hedged basis, but warn these trades now have limited upside.

"We think the EM equity trade likely gives way before the bond trade does," strategists Bhanu Baweja and Manik Narain wrote in a note.

To be sure, technical factors also account, in part, for recent weakness in commodity prices, current-account positions among the “fragile five” bloc 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 risks to the emerging market business cycle posed from China.

"I still think that the wide output gaps in some commodity exporters will lead to continued inflows, especially to local bonds," said Rachel Ziemba, the New York-based head of emerging markets at 4CAST-RGE. "However, if China keeps tightening, it’s not going to be pretty."

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