Emerging-Market rally pits Morgan Stanley against Goldman Sachs

Ignore cheap valuations and fade the rally, say strategists

Signs of stabilization in emerging markets since the start of the month are splitting some of Wall Street’s biggest banks on the outlook for the asset class.

Morgan Stanley strategists dubbed the recent recovery a “head fake” and recommended selling on gains in stocks and bonds. Their counterparts at Goldman Sachs Group say that developing nations “now offer relative value” and are keeping their long call on the MSCI Emerging Markets Index of equities. JPMorgan Chase & Co. agrees that valuations on emerging equities now look attractive, but concludes there’s “no hurry to move back” in this quarter.

The divergence reflects uncertainties surrounding the end-game of U.S.-China trade tensions that some fear could escalate to damage global economic growth, and those tied to the Federal Reserve’s monetary tightening. While emerging markets weathered the Fed’s policy normalization well last year and into 2018, that changed with a vengeance as the dollar started rallying in the second quarter and global funding costs started to climb.

The MSCI Emerging Markets Index has now declined for five consecutive months, with benchmarks from Shanghai to Manila sinking into bear markets with declines in excess of 20 percent from their recent peaks. The Bloomberg Barclays Emerging Markets Local Currency Government bond index has tumbled 2.5 percent this year after soaring 11 percent in 2017.

Both of those gauges have climbed over the past week, helped by reassurances from China issued July 3 that it wouldn’t pursue a depreciation of the yuan as a weapon in its trade battle with the U.S. With China as the largest emerging market of them all, prospects for an unanchored yuan had triggered fears of yet deeper declines for developing-nation assets.

“We don’t believe this is the start of a sustained recovery,” Morgan Stanley analysts including London-based James Lord warned in a July 9 note to clients, commenting on the recent period of calm. “Trade tariffs are going higher, a supply side-led rise in oil prices is under way, the U.S. yield curve is close to flat while QE is in reverse,” they wrote, referring to the Fed’s roll-back of quantitative easing.

Supportive Data

Goldman analysts including Caesar Maasry in New York wrote the same day that emerging markets should outperform in the second half of the year. Their rationale: investors have bailed out of the asset class due to worries about growth, but data for developing countries will start to stabilize in coming months.

Bank of America Merrill Lynch strategists including Ritesh Samadhiya in Hong Kong saw developing-nation equities as “a buying opportunity” in mid-June, and the bank said Tuesday that its house view remained unchanged since then and that it was “structurally bullish.”

For its part, Citigroup Inc. issued a report Monday saying it favors emerging stocks on their “growing resilience to external shocks as well as attractive valuations.”

JPMorgan advises a neutral position compared to developed markets. “Conditions might look right to turn more bullish on EM sometime entering” the fourth quarter, analysts including Pedro Martins Junior in Sao Paulo said in a July 3 note.

The Morgan Stanley team agreed that emerging-market assets look cheap, but concluded that the valuations for stocks and bonds aren’t low enough that they will protect investors against losses. Though they might fare better than developed peers, in absolute terms both should suffer alike, the bank said.