Warning signs flash for HSBC, Merrill 
in emerging-market rally

TOKYO • The backlash to the world’s most-popular trade is underway — the emerging-market (EM) rally has now gone too far, according to HSBC Holdings plc and Bank of America Merrill Lynch (BofAML).

A combination of potentially hawkish US Federal Reserve (Fed) surprises and already stretched performance has convinced HSBC strategists including Max Kettner to turn cautious on EM assets, while BofAML strategist Ralf Preusser thinks developing-nation bonds are vulnerable to positive US data releases.

“Cross-asset EM performance looks stretched, particularly for EM local currency debt and EM equities,” wrote Kettner and team in a note on Monday. “Might now be the time to reduce EM exposure in portfolios tactically, that is over three months? We think it is indeed time for a breather.”

EM assets have rebounded since the end of last year, as a dovish turn from many of the world’s central banks and growing optimism about US-China trade talks boosted risk assets. The MSCI EM Index of shares is up over 7% year-to-date and its currency equivalent has risen 1.3%. The Bloomberg Barclays EM USD Aggregate Total Return Index has gained about 3.5% in the period.

For HSBC, the asset class’ performance now looks stretched if history is any guide. It also seems plausible that any Fed surprises in the coming months will be to the hawkish side, which would pressure EMs, the strategists wrote. Even with a quick US-China trade resolution, relative upside would be constrained, they added.

Meanwhile, BofAML’s argument is centred around the strength of the US economy. Given its closed nature and the remnants of its fiscal tailwinds, there is a risk of upward pressure to both the dollar and US rates, which would be negative for EMs, Preusser wrote in a note on Monday.

“With dollar short positions notable, the US dollar move could be painful and exert pressure on EMs, he said. “As a result, we continue to prefer taking risk off the table in EMs directly.”

Still, not everyone is as cautious. With optimism growing over a resolution to the trade dispute, and its view that the dollar is likely to weaken as the Fed stays on hold, the outlook for EMs stocks is looking rosier, according to JPMorgan Asset Management. Amundi Asset Management and Hermes Investment Management are also arguing that a duller US economic outlook is an opportunity not to be missed for equity investors in developing markets.

Investing in EMs overtook the US dollar as the most “crowded” trade in BofAML’s most recent survey of global fund managers, the first time the asset class has held the top spot. — Bloomberg