Despite widespread civil protests across the U.S. and geopolitical tensions with China, an unprecedented rise in unemployment and continued concern about Covid-19, markets have been off to the races—including in emerging markets in what analysts are describing as a fear of missing out driven-mania. But the question for investors is if they should resist the “FOMO” rush when it comes to emerging markets. The mania could last longer and go further than fundamentals may suggest, Arthur Budaghyan, BCA Research’s chief emerging markets wrote in a client note Thursday that a weaker than expected global recovery and rising tensions between the U.S. and China pose two big risks that will continue to weigh on emerging markets “after this recent mania phase runs out steam.”
The iShares MSCI Emerging Markets ETF (EEM) has risen 10% in the past month, paring some of its earlier losses.
BCA Research’s recommendation to investors: Those who are already invested in emerging markets or can’t stay on the sidelines should stick with the rally with tight stop orders. But investors with a longer time horizon should wait for a pullback in emerging market equities and currencies. Here’s why: Global stocks have taken off even as forward earnings per share expectations deteriorate, pushing emerging markets’ forward price/earnings ratio to a decade high. “Any overdrive in asset prices without supporting fundamentals can last for a while but typically ends with a crash,” Budaghyan wrote. “During the March carnage, many investors operated on a ‘sell now, think later’ principle. Since the rally began, they have switched to a ‘buy now, ask questions later’ attitude.”
Institutional equity investors had been skeptical of much of the rally, with retail investors creating much of the momentum since March amid a spate of new brokerage account openings globally, according to BCA. But in recent weeks institutional investors have also started to add exposure to riskier assets, including cyclical stocks.
The more technical features of the recent global stock rally also give pause: Typically, stocks that have lagged behind are the last to catch up. And during selloffs outperformers are the last to be dumped. But this time around, Budaghyan notes that the most recent spike in global markets has been driven by underperformers, like emerging markets, Europe and value stocks—a sign bears could be throwing in the towel and suggesting it is the final phase of the rally, rather than the beginning.
While Budaghyan allows that the amount of stimulus pumped into the economies has been unprecedented, it is still unclear if it will be enough to deal with this recession’s particularities. And then there are also other headwinds: Budaghyan upgraded his growth outlook for China because of the country’s aggressive stimulus measures but the escalating U.S.-China confrontation and the risk that poses for “a relapse” in global stocks keeps him from recommending long positions in China-related stocks.
Global trade and industrial sectors need to recover for a sustainable rally in emerging markets, they add. And moves in China’s domestic A-shares market, especially cyclical stocks, suggest that is not yet happening. “Given China was the first nation to exit from lockdowns, its share prices should be the first to signal a sustainable economic recovery. Yet onshore share prices have been rather subdued,” Budaghyan writes. HSBC strategists this week offered an even more cautious tone on emerging markets, noting a lost decade broadly for the asset class after the global financial crisis.
Many economies have gone into the pandemic in less than fighting shape, with great need for structural and fiscal reform focused on infrastructure, education, labor market and health care to revive growth and “bring a shine back to the asset class,” HSBC emerging markets strategist Ali Cakiroglu wrote in a client note. Until these are addressed, Cakiroglu cautioned that emerging markets could face a protracted recovery out of the pandemic and remain a tactical allocation for investors rather than a strategic one.
Another reason to rethink joining the FOMO crowd when it comes to emerging markets broadly.