It’s a pattern that’s become familiar to investors in emerging-market assets — political unrest flares, the affected nation’s assets are roiled and…that’s that. And so it’s gone this week. Turkish equities were battered by news of a row with the U.S. while MSCI Inc.’s emerging-market stock index advanced, leaving investors wondering just what it will take to derail a rally that’s reached 61 percent since January 2016. For investment banks from JPMorgan Chase & Co. to Wells Fargo & Co. and Credit Agricole SA, the answer is simple — it won’t be an isolated political event, but either an unexpectedly hawkish turn from the Federal reserve or a slowdown in China’s economy.
“It needs one big negative thing for all of it to fall like a house of cards,” said Guillaume Tresca, a senior strategist at Credit Agricole in Paris. “And that’s an aggressive Fed or macro data from China, but so far, we don’t see any such risk. Investors continue to play the game.”
And why not? A gauge of emerging-market currencies has jumped 15 percent and stocks have gained in 15 of the past 20 months, while bond spreads relative U.S. Treasuries sit at the lowest levels in a decade. The bullishness persisted in the face of an attempted coup in Turkey, an impeachment in South Korea and a power struggle in South Africa. The U.K.’s vote to leave the European Union and the election of U.S. President Donald Trump caused short-lived ripples.
“I’m not worried about risks in a broadly diversified emerging-market portfolio,” said Brian Jacobsen, the chief portfolio strategist at Wells Fargo Funds Management in Wisconsin. “The valuations are still attractive and the growth outlook should be supportive. A selloff would likely happen from much higher levels than what we have today.”
Are Markets Pricing More Reflation or Tighter Policy?
That leaves investors to parse Fed policy and Chinese growth prospects for signs of the next event large enough to buckle emerging markets as a whole. For most investors, the Fed is a known risk and market prices already reflect a 75 percent chance for a rate increase of one-quarter percentage point in December. But the steward of that policy, Chair Janet Yellen, will see her term expire in February and the Trump administration reportedly is leaning toward replacing her.
Former Fed Governor Kevin Warsh rates as the front-runner, and he’s seen as the most hawkish of the candidates, meaning more rate hikes and a flatter yield curve. China, meanwhile, has sought to curb excessive speculation in stocks before the Communist Party’s twice-a-decade congress later this month. The country could witness a “mini cyclical slowdown” because the tighter policies will affect the property market, infrastructure spending and liquidity, UBS Asset Management said in September.
The International Monetary Fund, on the other hand, raised China’s economic-growth estimates for both this year and 2018. “We follow China very closely,” said Diana Amoa, an emerging-market debt portfolio manager at JPMorgan Asset Management in London. “China is probably the one emerging market where a significant slowdown in growth could see contagion across assets.”