Has the EMs rally still got further to go?

by Vinícius Andrade, Zijia Song and Maria Elena Vizcaino

Investors are betting the months-long rally in emerging markets has further to run even as tariff threats and escalating geopolitical tensions signal a rocky path ahead.

Money managers from Lazard Asset Management Ltd. to Pictet Asset Management Ltd. have been scooping up Latin American local bonds, Asian currencies and some high-yield sovereign debt. The optimism — fueled by fading concerns about Trump’s trade policies — got a fresh boost last week after a string of soft US inflation data reignited bets the Federal Reserve will lower interest rates more than once this year. That helped send the dollar to 2022 lows, pushing EM assets to extend yearly gains. 

“Increasing momentum in the weaker dollar narrative and a still structurally elevated valuation for the dollar suggest there is much more room to go for EM local as an asset class,” said Chris Preece, a portfolio manager at Pictet. “Sure, there can be a pullback — but I don’t think we can say the move in FX has been over-extended.”

Emerging markets have been on a stellar run: currencies are having the best start to the year since 2009, stocks are beating the S&P 500 Index and local bonds are on a tear. The jump left the extra yield investors demand to hold junk-rated dollar debt from the developing world over Treasuries at the lowest in almost four years. 

That has made assets more vulnerable to looming US policy risks and the escalating conflict in the Middle East. The latest reminder came at the end of last week, following Israeli airstrikes on Iran. 

For Morgan Stanley strategists, that means traders “will need to hold their nerve” going into the second half. 

“The next few days will be critical to this, but we would think there is a higher bar for markets to panic” given previous experiences of conflicts between Israel and Iran over the last two years, JPMorgan Chase & Co. strategists including Jonny Goulden and Saad Siddiqui said Friday. They reaffirmed an overweight recommendation for EM currencies. 

Markets on Monday showed some of that optimism as both the EM currency and stock indexes posted gains. Israel’s shekel rose the most in the world, while stocks tied to artificial intelligence and defense contracts rallied.

Comeback

The asset class is also seeing a pickup in inflows after multi-billion dollar outflows over the past three years. The rebound comes as money managers seek to diversify away from the US, where questions about growth and policies are eroding sentiment after years of outperformance. 

EM bond funds saw $738 million of inflows in the week ending June 11, the biggest this year, according to JPMorgan Chase & Co. citing EPFR Global data. A $3.2 billion exchange-traded fund focused on local government bonds in emerging economies attracted $255 million in May, the most for a month since 2019.

“We are seeing flows coming back into the asset class from foreign allocators,” said Nicolas Jaquier, portfolio manager at Ninety One Plc.. “But also domestic investors in EM generally have been very long dollar for a long time and we’re seeing a bit of a reversal of that trend.”

Asia FX

Arif Joshi, who co-heads EM debt at Lazard, has rotated out of emerging Europe currencies to turn more constructive in Asia. Some of his preferred wagers include the Taiwan dollar, the South Korean won and the Malaysian ringgit.

Anders Faergemann, a portfolio manager at PineBridge Investments, is adding currencies like the Czech koruna and Hungarian forint which benefit from the Eurozone’s strength. In Asia, where trade risks have pressured assets, he likes the Taiwanese dollar, Korean won and Indian rupee. He also favors local assets in Mexico that offer high yields as the USMCA trade agreement is set to prevail and limit volatility. 

“While we have come a long way already in EM local this year, largely due to the softer US dollar trend, we can see the current developments extending further into the second half irrespective of the July 9 deadline,” he said, referring to the end of President Donald’s Trump truce for tariffs. 

Pullback 

Still, some money managers are warning US debt ceiling negotiations and Trump’s back-and-forth on levies have potential to send volatility — which has come down following Liberation Day — jumping again. 

“While we believe EM currencies have a lot of upside potential in the medium term, we have tactically reduced exposure to them,” said Antonina Tarassiouk, a senior analyst at Reams Asset Management. 

Brazil’s real, which has strengthened 11% versus the dollar this year, would likely come under pressure in a risk-off scenario driven by tariffs, she said.

“The market kind of got ahead of itself and is totally riding off any trade risks or Trump policy risks,” said Aaron Gifford, a senior EM sovereign analyst at T. Rowe Price. “It’d be prudent for investors to take some chips off the table.”   

To Invesco Ltd., it’s not the time to be out of the market. 

“You may want to restructure some trades with these potential hiccups in mind but you also want to stay the course in this asset class,” said Wim Vandenhoeck, co-head of EM debt at the firm. 

What to Watch

• Brazil and Chile policymakers to decide on interest rates, with the former likely declaring the end of the tightening cycle and the latter expected to hold its benchmark rate at 5%
• Central banks in Turkey, Indonesia, the Philippines, Taiwan and Pakistan also hold monetary policy meetings
  • Economists surveyed by Bloomberg expect officials in the Philippines to bring rates down closer to neutral while the rest might keep rates unchanged

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