Peak Complacency? The Hedges Are Coming Off In Emerging Markets

As is the case with high yield, this is probably a good time to ask yourself how long you want to stick around in EM.

To be sure, the low vol environment naturally favors carry trades and no matter how hawkish the Fed rhetoric, the dollar can’t get off the mat (thanks in no small part to Trump, who has succeeded in driving the dollar lower although probably not for the reasons he would have preferred).

A June hike is pretty much fully priced, and that hasn’t derailed things either.

Have a look at YTD flows:

ETFFlows

Meanwhile, spreads have compressed to their tightest since 2014:

EMSPreads

This despite the intractable political turmoil in Brazil, the perpetually precarious nature of Turkish politics, the unpredictable character of China’s tightening efforts, and a whole laundry list of other concerns that, all else equal, should at least be tempering investors’ excitement if not triggering an unwind.

As Bloomberg notes, the Street is starting to curb its enthusiasm – if only at the margins:

Credit Suisse Group AG forecasts developing-nation equities will underperform in the short term, while Deutsche Bank Wealth Management said it’s not as positive on emerging-market bonds as a year ago. Goldman Sachs Group Inc. said strong returns have partially eroded a previously compelling valuation signal, and BNP Paribas SA said the best gains in markets such as India and Indonesia may already be behind us.

But as we noted last week in “‘This Sort Of News’ Is Bad, But ‘There’s A Wall Of Money Out There’“, Barclays thinks this party isn’t over by any stretch. Here’s an excerpt from the bank’s latest on EM:

Although political developments continue to inject some volatility into parts of the EM asset universe, specifically in Brazil and South Africa, a sense of calm appears to have returned to broader markets. Despite the latest Caixin PMI falling more than consensus expectations to below 50, there have been some signs of near-term stabilisation in the slowdown of China’s growth. This has likely alleviated concerns that a cycle of weaker growth in China could extend the recent weakness in commodity prices and ultimately change the global macro narrative that has supported steady inflows into EM funds.

Flows have not been derailed either by the recent political turmoil in Brazil. We think the case for a sustained negative contagion from Brazil into the broader market is weak; and we hence expect the global macro environment, rather than idiosyncratic political EM developments to drive the outlook for flows. This argues for a continuation of the low volatility environment. We see little sign of any reversal in the near term given the absence of major known risk events and maintain our constructive stance towards carry trades.

Whatever you choose to believe and whether or not you think EM can remain Teflon in the face of political turmoil and a Fed hiking cycle, you’d do well to note that apparently, investors have gotten so confident in this trade that they’re removing their hedges.

Shorts

“Investor positioning data for the CDX EM index indicates that investors increasingly appear to subscribe to [the sanguine view],” Barclays goes on to say.

Right. Of course when people get so confident in crowded trades that they start to take off their hedges, that’s usually a sign that even the “smart” money has become “stupid.”

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