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. 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.
"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.