Emerging market stocks have been roaring this year. That is hardly surprising as the strong rally in stocks here in the U.S. and elsewhere has largely been about optimism. Whether you attribute that to Trump’s election or a more general sense that the prospects for global growth are improving, the fact is that what is driving equity appreciation at these levels is an expectation that we are entering a more inflationary period around the world, and optimistic investors are far more comfortable with risk.
Emerging markets, as one of the riskiest asset classes, has benefitted but that also means that it will be the first place that a change in sentiment will show. That is why traders and investors should keep a close eye on the iShares Emerging Market ETF (EEM) in the coming weeks.
There is one primary reason to believe that that change in sentiment is approaching; the market has begun to ignore bad news. Moody’s downgraded China’s sovereign debt rating this week, a move that would normally produce a negative reaction in emerging market stocks in general given the importance of Chinese growth.
In this possibly over-optimistic environment, however, that news doesn’t register at all on the five-day chart for EEM.
Moody’s announced their downgrade on Wednesday, and as you can see EEM opened flat that morning and gained during the day, before surging overnight. The “bad news” doesn’t register at all. Now it is quite possible that Moody’s are being overcautious, that is their usual MO after all. (Anybody remember the downgrade of US debt a couple of years ago?)
The fact is that their analysis is based on facts and data rather than sentiment, and those things have a way of showing in markets eventually.
The market dynamics driving the rise in emerging market pricing is not all about optimism. It is also a result of central bank policies outside the U.S. Far from making the situation less worrying, however, that is even more cause for concern. The Fed may have begun a process of tightening monetary policy and raising rates but the world’s other two major central banks, the BOJ and the ECB, are still adding liquidity to markets by buying up assets; bonds in the case of the ECB and even equities in the case of the BOJ.
In effect, what that does is to hand big wads of cash to finance houses while at the same time reducing the return on fixed income assets and pushing equity valuations higher in their own markets. In the modern global economy that forces those banks and investment companies to look for a return elsewhere, which has been at least in part what has driven U.S. markets to new highs and has also driven emerging market stocks upwards.
That is a distortion of sorts, but makes sense for those investors if there is good reason to believe that growth is coming. When that assumption is called into doubt, however, as should have happened following Wednesday’s note of caution from Moody’s, one would expect a reversal, even if only a temporary one.
But as the chart above shows, buying intensified from Wednesday to Thursday.
In the short term, that level of resilience in a market makes it a good place to be, and the logic of riding the wave of optimism in a volatile market like emerging market equities is obvious, possibly too obvious. The more bad news is ignored, the more crowded the emerging market trade becomes. Squeezing into a crowded trade is never a good idea.
Investors who have ridden the wave this year would therefore be wise to think about getting out before the rush for the exit begins, and others should watch EEM for signs of trouble that could easily spread as sentiment shifts.