Warning lights are flashing for emerging market investors

The increasing trade war between the US and China has struck dread into emerging market investors and provoked a wave of outflows from EM capital markets. Analysts predict that it could be just a foretaste of what is coming. Foreign money has left EM assets at a flow of more than $5bn a week since US president Donald Trump toughened his line against Chinese imports on May 6.

However, even after these recent outflows, foreign investors have accumulated net positions in EM assets of more than $30bn for the year to date. Many investors appear to be staying put in the judgment that the quarrel will be over before long. While prospects for a resolution persist, prices have further been stimulated by the unanticipated vitality of the US dollar, which many investors wrongly thought would diminish this year, boosting EM currencies.

While EM corporate and sovereign bonds issued in foreign currencies are at year-to-date highs, local currency assets – equities and government bonds – have suffered, down 10 percent and 3 percent, respectively, from their 2019 peaks. Yet they remain net positive for the year — but only just. Local bond prices have fallen slowly and erratically from their peak in late January.

Markets are witnessing an unwinding of positions taken since January, but not ultimately a rebalancing of significant positions built up over the past several years. So the short-term question is whether to safeguard profits by reducing positions taken in the first quarter and the longer-term question is what to do with those big, strategic risks.