CREDIT SUISSE: Here's why the emerging markets rally may be about to end

Buoyed by diminished expectations for rate hikes from the US Federal Reserve and fiscal stimulus acting to stabilise economic growth in China, emerging markets have enjoyed a stellar run in October.

Stocks, high-yielding debt and emerging market currencies have been screeching higher, aided in part by a fair degree of short covering from investors.

While the movements so far have had little to do with an improvement in emerging market fundamentals, according to Ray Faris and Trang Thuy Le, research analysts at Credit Suisse, those seen so far this month could extend until the October US non-farm payrolls report is released on November 6.

Here’s Faris and Le on the recent recovery seen across emerging markets.

“The recovery in EM assets that accelerated after the US September payrolls disappointment is beginning to shift from being about cutting of shorts to reengagement of longs. The IIF estimates that after large outflows from EM assets in Q3, inflows have surged over the past week. EM currencies and equities have been the main beneficiary of these flows so far.”

The charts below, supplied by Credit Suisse, reveal the recovery in emerging market currencies and credit spreads seen so far in October.

While the pair believe the recent run of emerging market strength could continue in the weeks ahead, Faris and Le believe the underpinnings of further gains in emerging markets remain fragile.

“We judge the market’s recent change of heart about EM assets as resting on two pillars: delayed Fed hikes and an expectation that fiscal stimulus is stabilizing growth in the Chinese economy,” they wrote.

On the latter, the pair note that chatter about increased fiscal stimulus in China has seen metals prices rise modestly so far in October, something that has also contributed to recent strength in emerging market currencies. While that has buoyed sentiment short term, they suggest that “Chinese stimulus will probably need to push commodity prices higher, not just stabilise them,” if gains in currencies are to continue.

Towards the Fed, Faris and Le suggest the markets have got ahead of themselves in pushing back expectations for future monetary policy tightening.

“We estimate that the market has gone from pricing a cumulative 25bps of Fed hikes through the January 2016 meeting on September 17 to now pricing a full hike only by August of next year,” they said.

Given the Fed outlined that concern about emerging market weakness, particularly in China, was a factor in deciding to delay lifting interest rates at its September FOMC policy meeting, Faris and Le believes this creates two risks for the emerging market rally in the period ahead.

“One is that if China’s growth does indeed recover somewhat it would increasingly remove a key reason behind the Fed’s delay at the September meeting. The stronger and sooner the Chinese recovery, the more the market will have to pull forward Fed hikes and increase pricing of the terminal rate, in our view.”

In essence, should Chinese economic data continue to improve, it will remove one of the key impediments to the Fed lifting interest rates, at least as communicated in September. As China’s economic data data improves, so too will the odds of the Fed tightening interest rates, if you will.

Faris and Le believe that without a “sustained surge in Chinese growth,” something that they see as unlikely, it’s unlikely that the rally in emerging market assets can continue.

Later today, China’s government will release industrial production, retail sales and urban fixed asset investment figures for September, along with Q3 GDP. Given recent developments in the Chinese economy, markets may pay greater attention to the September data rather than the more-dated Q3 GDP number.

If there are signs that momentum in the Chinese economy is accelerating — something that would normally be perceived as bullish by markets — it may well also support expectations that Fed may be closer to raising interest rates than markets currently expect.

All four data releases are scheduled for 1pm AEDT.

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