NEW YORK (Reuters) - Emerging market equities in the second quarter have undergone a rebirth of sorts, rebounding from severe underperformance over the prior 12 months to flirt with the best levels in a year, but analysts say warning signs are flashing.
Major emerging markets like Brazil and India have benefited from cheap borrowing in U.S. dollars and hopes that elections will translate into economic reforms. Valuations in these markets are also historically cheap.
But the redeployment of borrowed U.S. dollars into traditionally higher growth markets, also known as the carry-trade, could be fueling an unrealistic outlook.
“I do not believe any of this is being driven by growth. It is being driven by a carry trade and driven by reforms or expectations of growth coming from those reforms,” said UBS emerging markets equity strategist Geoff Dennis.
“You have seen no evidence, in our opinion, net-net across emerging markets that the growth story is getting better, whether you are looking at the economic growth story or indeed the earnings growth story.”
The carry trade has proliferated as benchmark 10-year U.S. Treasury yields hit 11-month lows around 2.42 percent. The likelihood U.S. zero interest rate policy, or ZIRP, holds for another year, along with similar efforts out of Europe and Japan, favors emerging markets.
One indication of short-term investor interest is the record high long positions held by speculators in MSCI emerging market index futures, CFTC data shows. And emerging market equity funds have now had inflows three months running, according to Lipper, a Thomson Reuters company.
India’s benchmark index was up 5.6 percent at the end of March and year-to-date is up 14.4 percent, rallying further after the recent victory of business-focused Narendra Modi for prime minister.
Brazil’s benchmark index was down 2.1 percent at the end of March. Now it’s up 1.4 percent for 2014. The economy in Brazil has faltered, but the rally was fueled by recent polls showing incumbent President Dilma Rousseff’s lead shrinking ahead of an October election that so far has been overshadowed by next month’s World Cup.
“That alone is good news because even if she does win but not in a landslide, the message will be things need to change,” said Will Landers, Latin America equity portfolio manager at BlackRock.
Landers favors banks in Latin America and in Brazil specifically, despite recent gains, saying these companies should see return on equity expand in the next year or two, which should warrant higher valuations.
Emerging market equities have rallied 3.62 percent so far this year, versus 3.88 percent for the U.S. benchmark S&P 500. Still, emerging market stocks are inexpensive, according to at least one measure.
The MSCI Emerging Markets Stock index sports a 12-month forward price-to-earnings ratio of 9.97. That is less than the 10-year average of 10.80. By comparison, the S&P 500 is trading at 15.4 versus a 10-year average of 13.8, according to Thomson Reuters data.
Bank of America-Merrill Lynch analysts said investors could keep taking on risk, including emerging markets, as volatility remains low. But they said the bond-market rally will eventually end due to increased questioning of the “assumption of ZIRP to infinity,” and that would pose risks for emerging markets.
“We stick with the view that a summer melt-up would likely be followed by a nasty correction in the autumn,” they said.
UBS’s Dennis thinks emerging-market equities could gain 10 percent this year, but money will shift toward defensive nations such as South Korea, Taiwan, Mexico, Poland and Colombia.
Win Thin, global head of emerging markets strategy at Brown Brothers Harriman in New York, said some of the rebound was a reaction to oversold positions.
“The bottom line is, pick countries with strong fundamentals because it is not going to be a broad-based rise,” he said, forecasting top equity performers from Singapore, Hong Kong, China, Peru and Russia.
Reporting By Daniel Bases; Editing by David Gregorio