“A Small Spark” Could Trigger An EM Correction, But For Now: “No Bears Allowed”

Over the past couple of weeks, we’ve variously noted that when it comes to the usual EM risk suspects (hawkish Fed policy, flights to safety occasioned by geopolitical turmoil, etc.), emerging market assets just don’t seem to give a fuck.

You’ll recall what we said on the way to noting the rather amusing fact that earlier this month, the Vanguard FTSE EM ETF got its biggest daily inflows since 2012 ($872.5M) on a Fed Minutes day:

Attribute EM resiliency as you see fit. That is, maybe the Q1 outperformance was due to the fact that the dollar had a terrible go of it. Or maybe it was partially due to the fact that the March Fed “hike” was actually a “cut” if you care to consult financial conditions. Or maybe no one is buying what the Fed is selling in terms of their intentions. Or maybe today’s portfolio managers are too young to remember what a tightening cycle actually is.

Whatever.

Here’s a quick bit of color from a halfway decent article that appeared in the Journal last week:

A crack is forming in an emerging-market revival that channeled almost $60 billion into assets of developing economies during the first months of 2017.

Now, worries are setting in that the buying spree, which helped give emerging-market stocks and currencies their best quarter in two years, has resulted in lofty valuations as geopolitical tensions escalate. Yield-seeking portfolio managers who made widespread purchases could be just as indiscriminate when it comes to selling, market watchers say. And downturns could last a long time: The MSCI Emerging Market Index fell three years straight before notching a gain in 2016.

[…]

But money rushing into assets of developing nations suggests a search for yield could be trumping traditional metrics like a country’s economic and political outlook. Foreign investors poured an estimated net $29.8 billion into emerging-market stocks and bonds in March, the highest monthly total since January 2015, according to the Institute of International Finance. Nearly three-quarters of that total—$22 billion—went into Asia.

“There’s this capital coming into emerging markets and it needs to be invested somewhere,” said Mark Baker, emerging markets fixed-income portfolio manager at Standard Life Investments in Hong Kong.

The “an EM correction is coming” thesis took a hit from Sunday’s “benign” outcome in the first round of the French elections. Or maybe that’s not exactly right. Maybe we should say “the EM correction thesis took a hit from pollsters’ ‘win’ in the French elections,” because as one trader noted this morning, “there were times last night when there seemed to be as much relief from the forecasts being accurate as the diminished likelihood that one of the extremists will win the ultimate prize.”

Call it what you will, but whatever you do, call it bullish for EM – or at least that’s what everyone is saying on Monday. Here’s a summary from Bloomberg:

Currencies of Czech Republic, Hungary and Poland rose against the euro after pro-European Union Emmanuel Macron emerged as the front runner in France’s presidential election. Developing-nation stocks and bonds climbed.

“’Risk on’ theory may get better support this week. This is good for carry currencies” including South African rand, Turkish lira, Brazilian real and Russian ruble: Citi

MSCI’s EM index of currencies against the U.S. dollar advances 0.5%, heading for the highest close since 2014; stocks gauge rose 0.6%, most on closing basis in 3 weeks.

Yield premium on developing sovereign bonds over U.S. Treasuries falls 7bps to 306: JPMorgan Chase indexes.

Bloomberg Dollar Spot Index drops 0.6%, heading for lowest close since Nov.

Right. Well consider that, along with the following assessment from BofAML who notes that there were “no bears allowed” in their recent DC meetings.

No bears allowed in DC

The DC meetings confirmed our view that EM debt is likely to go beyond what fundamental valuation would dictate in Q2-Q3. Investors are bullish and very involved in EM as they continue to get flows and/or market conditions are benign. Despite the 16 weeks of inflows into EM debt, positioning is not that extreme, as investors have been reducing risk in last few days ahead of binary events. Market participants agree that valuations are stretched but carry seems to be the only game in town.

Local is favored over external debt as FX/rates offer most value. Investors are struggling to find value in the usual suspects, increasing focus on bottoms-up analysis of high yield but smaller markets. Our sessions on the less traditional countries had very strong attendance. The focus was more on country specifics rather than global themes.

Concerns about EU elections, US policy and China all appear modest. Investors’ baseline scenario is a benign outcome in France and no game-changing swings in US fiscal and trade policy. In that environment, US rates would remain range bound, which supports EM inflows.

However, there is also agreement that a small spark could trigger a correction. The most cited concern is that iron ore and China lead indicators suggest that growth is peaking. Some clients expressed concerns on ECB hiking and inducing a bear steepening in global rates, which could be negative for EM.

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