Dollar’s strength, trade war could stymie EM stock rally

The four-month rally in emerging markets appears to have lost steam, with the recent appreciation in the dollar and tariff skirmishes between the world’s two biggest economies dimming investor appetite for risk.

The MSCI EM index — a gauge used by global fund managers to benchmark their emerging markets performance — dropped 9 per cent in May, its worst performance since August 2015. The slide in EMs has resulted in market-cap erosion of more than $1.1 trillion. The MSCI EM index is trading at 11.3 times its one-year forward projected earnings, a 2.5 per cent discount to its five-year average.

Trade tensions between China and the US have affected EM currencies, reflecting the slide in risk assets. The MSCI EM currency index’s 50-day moving average has dropped below its 100 DMA, resulting in a technical formation called ‘death cross’ that indicates a bearish pattern.

The biggest concern for EM equities is a slide in the Chinese yuan against the US dollar. The yuan is currently trading at 6.92 and dropped 2.5 per cent in May, the most significant loss in Asia. EMs saw a deep correction in December 2016 when the yuan slipped below seven a dollar. Citigroup believes a drop below seven a dollar for the yuan could trigger a sell-off in stocks, pointing to competitive devaluation and broader financial instability.

EMs are underperforming developed nations by 8 per cent since the beginning of the year and witnessed sharp outflows in the past one month. Outflows from EMs could weigh on the performance of Indian equities as well.

India, too, has reported deceleration in FPI flows in May. After receiving nearly $10 billion between February and April, net FPI flow in May moderated to $867 million, which is a quarter of the last three month’s average of $3443 million.

The MSCI India index outperformed the MSCI EM index and MSCI World index — the latter a gauge for the developed world — by 21.2 per cent and 8.9 per cent, respectively, in the past one year.