Don’t get too excited about the rally in emerging markets (EM) over the past three months. According to Morgan Stanley’s emerging markets strategy team, it was nothing but a bear market rally with the risks of a reversal now building yet again.
In a research note released today, Morgan Stanley suggests the factors that led to the previous rout in emerging markets may be about to make a return.
“The pillars that supported the EM rally earlier this year seem to be crumbling, as risk conditions have turned and have started to expose weak fundamentals and structural imbalances once again,” they say.
“The strong USD trend has resumed, and with Chinese data deteriorating and the Fed sounding more hawkish, two of the key pillars supporting the rally from February to April are now diminishing. Oil has been the odd one out, holding up relatively well, but if supply-side constraints fade, this would become a key risk factor.”
It’s enough to raise a cold sweat among investors, particularly given some of the carnage witnessed in the first six weeks of 2016.
Back then, the combination of a stronger US dollar, concerns surrounding the Chinese economy and plummeting crude prices was toxic for risk assets, particularly in emerging markets.
If that happened then, why not now?
It’s safe to say very few think the imbalances leading to that sell off in the first place have been resolved in the past three months – more papered over by a pullback in the US dollar which helped to boost investor sentiment. Extreme short positioning, and an unwinding of those bets, did the rest.
Given recent events, along with signs that history could potentially repeat, Morgan Stanley isn’t taking any chances, slapping an underweight rating on all emerging market asset classes it covers.
We are now bearish on all three sub-asset classes and expect negative total returns in USD over the next three months. We move both local and hard currency sovereign debt to underweight from neutral, while remaining underweight EM currencies. We have also reduced the beta risk in our local currency portfolio by shifting away from some of the high-yielding opportunities to lower-beta bonds, while we maintain a very cautious country allocation in sovereign credit.
To recap, in broad terms, Morgan is bearish on everything emerging markets related, short term.
As a perceived lead indicator, recent weakness in emerging market currencies helped underpin this view, providing the proverbial “canary in the coal mine” for what may happen in other asset classes.
Beyond the short term, strategists at the bank are equally as bearish, suggesting private sector debt levels — be they corporate or households — remain “largely unresolved problems”.
“Recent data suggest that corporates and households in EM continue to increase leverage, while NPLs [non-performing loans] are still on the rise,” says Morgans.
Though they do not expect a full-blown debt crisis, strategists at the bank believe high levels of indebtedness will exacerbate deflationary pressures, and as a consequence future economic growth.
“To be clear, we are not calling for another debt crisis, but the cost of not dealing with the EM debt problem exacerbates deflationary pressures and will likely hinder growth and efficient allocation of capital on a sustained basis,” it says.
“As (we) highlighted in a recent note, leverage globally has increased as a result of falling interest rates, in part due to the impact of demographic trends. With the Fed likely to increase interest rates, and the downward pressure on interest rates resulting from demographic trends likely over, leverage should pose a greater challenge going forward.”
This, in Morgan’s view, will likely be problematic, particularly given the rapid increase in leverage, led by China.
“Any increase in US yields will have an impact on global interest rates, even in places where economic recoveries may not be strong enough to weather the challenge of higher borrowing costs.
“This, in our view, is a major problem for emerging markets.”
A major problem for not only emerging markets, but also policymakers at the US Federal Reserve.