Morgan Stanley: Emerging Market Pillars Seem to be Crumbling

“May has brought significant atmospheric changes to EM, marking the likely end of a three-month bear market rally. Our base case for the next three months is now for EM sovereign spreads to widen by about 80bp and for EM local rate yields to back up by 30-40bp on an aggregate level. This implies negative total returns for both sovereign credit as well as local markets (in USD terms, and marginally negative on a local currency basis). In short, we believe that the risk is clearly skewed to the downside from here.”

“The strong USD trend has resumed, and with Chinese data deteriorating and the Fed sounding more hawkish, two of the key pillars supporting the rally from February to April are now diminishing. Oil has been the odd one out, holding up relatively well, but if supply-side constraints fade, this would become a key risk factor.”

“We are now bearish on all three sub-asset classes and expect negative total returns in USD over the next three months. We move both local and hard currency sovereign debt to underweight from neutral, while remaining underweight EM currencies. We have also reduced the beta risk in our local currency portfolio by shifting away from some of the high-yielding opportunities to lower-beta bonds, while we maintain a very cautious country allocation in sovereign credit.”

“Recent data suggest that corporates and households in EM continue to increase leverage, while NPLs [non-performing loans] are still on the rise.”

“To be clear, we are not calling for another debt crisis, but the cost of not dealing with the EM debt problem exacerbates deflationary pressures and will likely hinder growth and efficient allocation of capital on a sustained basis.”

“As (we) highlighted in a recent note, leverage globally has increased as a result of falling interest rates, in part due to the impact of demographic trends. With the Fed likely to increase interest rates, and the downward pressure on interest rates resulting from demographic trends likely over, leverage should pose a greater challenge going forward.”

“Any increase in US yields will have an impact on global interest rates, even in places where economic recoveries may not be strong enough to weather the challenge of higher borrowing costs.”