Short-Lived Rally for EM Views

2018 is on pace to be just the second year post  that all major EM asset classes post a negative return. Nevertheless, emerging markets have rallied over the past month, and two macro narratives have seemed to improve at the margin (trade and Fed policy). We do not expect these accomodative shifts to be long-lasting, but we do see further upside in the near term.We can explain EM’s weak returns through a simple factor model capturing growth deterioration (via our CAI measures), Fed policy (via US 2-year rates), and trade tensions (via the CNY). Importantly, most of the underperformance of EM seems attributable to the weakening of growth. While our base-case forecasts point to EM growth improvement (easier China policy, fading of negative impulses, and early cycle dynamics in some EMs), we acknowledge that macro investors are in “prove it to me” mode vis-a-vis EM growth.

Historically, EM assets have not been able to rally for more than 2 months without growth data improvement. In other words, the narrative of a dovish Fed and de-esclating trade tensions alone could probably drive EM only incrementally higher. In addition to our macro factor model, we assess EM asset moves relative to their historical relationship with core markets (our Wavefronts model). On both these measures, we see only limited upside in a potential further rally for EM equities (+5%), EM local rates (20bp lower), and EM credit (10bp tighter for the largest 19 markets).

Our preferred investment recommendations are relative value in nature. Specifically, we highlight our preference for MSCI EM vs. MSCI EAFE (non-US DM equities) and have raised our target .