Powell's U-turn makes EM equities most favoured among fund managers.
The February survey of global fund managers by Bank of America-Merrill Lynch says that 'Long Emerging Markets' is now the most crowded trade.
And why not? With Jerome Powell in a patient avatar as the head of the Fed, rate hikes are off the table and the central bank's balance sheet contraction may soon follow suit - at least that is what the markets believe. Inflation has continued to be low, which means the Fed has no reason to go for a rate hike. It is little wonder then that risk is on and emerging markets are the darlings of investors. The BofA-ML survey finds allocation to EM equities jumped 8 percentage points to a net 37 per cent overweight.
Can it go higher? Yes, it could because the allocation to EM equities is still 0.8 standard deviations below its long-term average. So there’s still ample juice left for it to go higher. In April last year, fund manager overweight to EM stocks was as high as a net 43 percent, well above current levels.
What is interesting is that even though global stock prices are up 7 percent since the January fund manager survey, yet global equity allocations in February fell to their lowest levels since September 2016. Cash with fund managers is high and the narrative in the markets is about 'secular stagnation' with both growth and inflation expectations low. In fact, the headline for the survey is 'My Big Fat Buyers' Strike.
The survey says that trades playing on the secular stagnation theme are big "longs" on cash, pharma, discretionary, EM, REITs; while big "shorts" are cyclical sectors like energy and industrials.
The assumption probably is that emerging markets will withstand the secular stagnation theme better than developed markets. It could also be the EMs are cheaper - the MSCI China index is up a lot year to date, which indicates investors have a rather complacent attitude to risk there.
Nevertheless, a word of caution is warranted. The BofA-ML survey is often taken as a contrarian indicator. However, these crowded trades could continue for months, as has happened with the long dollar trade, for instance.
Those surveyed also said the US dollar is the most overvalued since 2002. How is it that a strong dollar and an overweight on emerging markets go hand in hand? An EM rally will need a weaker dollar. Perhaps the reasoning is that EM is seen as a safe haven from the global growth scare and if fund managers have been putting their money in EM in spite of a strong dollar, it does say something about the strength of EMs.
That said, unfortunately the Indian market has not participated in the rally, for a variety of reasons ranging from weakness in certain corporate groups, worries over populist policies, high valuations in certain sectors and finally because of the forthcoming elections. As of February 12, MSCI India had given a negative return of -1.78 per cent year to date, in US dollars, compared to a gain of 7.5 per cent for EM Asia and 7.9 per cent for the MSCI EM index. Worse, the MSCI India Mid cap index is down over 9 per cent year to date, while the EM Mid cap index is in positive territory. That underlines the fact that most of the Indian market is down in the dumps.
The weakness in the Indian markets is also seen from the fact that the recent rate cut by the Reserve Bank of India did not rigger a rally in the markets, nor did the low inflation print and the prospect of rate cuts to come.
Nevertheless, BofA-ML says that globally, Q1 is likely to be positive for risk assets, which should provide support for Indian markets too.What could change the overweight on emerging markets equities? BofA-ML says that the contrarian trades such as long stocks-short cash, long energy-short healthcare, long EAFE (Europe, Australia and the Far East) -short EM, are all contingent on appearance of global ‘green shoots’. In other words, BofA-ML is saying that any signs of improving global growth could lead to some fund flows going back to the developed economies. A successful conclusion to the US-China trade talks could be the most likely trigger.