MORGAN STANLEY: The sell-off that has rocked emerging markets is far from over, and it’s headed for the US

via MS

  • Developed-market assets, including US stocks and credit, are not immune to the conditions that have dragged down emerging markets this year, according to fixed-income strategists at Morgan Stanley. 
  • They flagged slower global growth, higher oil prices, and trade disputes as some of the causes of the EM sell-off that would put US stocks under pressure. 
  • They advised clients to pull even more money out of emerging markets, and offered three trade recommendations in the FX market.   

The recent slump in emerging markets could worsen and hit US assets, according to fixed-income strategists at Morgan Stanley.

Massive divergence developing in SPX500 versus EEM

They’re not giving clients the all-clear to use the EM weakness as a buying opportunity. In fact, they’ve turned more bearish on developing markets in the wake of a sell-off that intensified last week as the Turkish lira crashed to record lows.

“Valuations are (even) cheaper and positioning is (even) lighter, yet we don’t think it’s time to add back risk and recommend de-risking EM portfolios further,” James Lord, the global head of EM fixed income strategy, said in a note on Thursday. “Expecting asset prices to come under more pressure in the coming weeks, both EM and DM, we move further overweight low-beta countries.”

Investors flocked to emerging markets last year to take advantage of a rare period when many of the world’s economies were expanding at the same time — a phenomenon described as synchronous global growth. Additionally, some investors wary of high US equity valuations looked elsewhere for better bargains.

But this year, slower global growth, the trade dispute between the US and China, higher oil prices, and the unwinding of the Federal Reserve’s balance sheet are a few of the reasons why EM isn’t repeating its stellar performance of last year, according to Lord.

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“Supporting our bearish stance is that we don’t think that DM will be immune to the global factors highlighted above, with the S&P 500 and US credit coming under pressure,” he said.

These factors don’t include a debt-induced financial crisis, which some strategists say would spare the US economy. According to Wells Fargo, US banks are exposed to just 5% of EM assets, and American exports to developing countries are equivalent to 15% of gross domestic product.

Lord added that emerging-market fundamentals are still stable overall, and not every country is equally vulnerable to a market shock. “However,” he said, “vulnerabilities in one country spread not only via fundamental linkages but also financial ones, as shown by asset performance in recent days, making it harder to find the outperformers.”

Lord and his colleagues, however, picked out a few trade recommendations for clients that all bet against EM assets:

  • Short the ruble against the Japanese yen (RUB/JPY)
  • Short the South African rand against the yen (ZAR/JPY)
  • Go long the dollar against the Mexican peso (USD/MXN)

When investors are skittish about a particular country, the currency market is usually one of the first places where their fears are expressed.

EM currencies show US investors are stampeding this year, with the Argentine peso down 32% against the dollar, the Turkish lira down 21%, and the Brazilian real down 12%. Only Colombia and Mexico’s currencies have gained against the dollar, both by about 4%, according to a ranking compiled by Bloomberg.


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