‘Something needs to give’: Wall Street is getting nervous about a red-hot part of the market

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An investor looks at a computer screen showing stock information at a brokerage house in Shanghai January 4, 2013.

Aly Song/Reuters

A lot that can go wrong for emerging markets has gone wrong this year.

The US dollar has regained all of its losses for this year. US interest rates have continued their ascent. The US and China, the world’s two largest economies, have exchanged blows over trade. President Donald Trump has threatened to upend the North American Free Trade Agreement.

And yet, for a while, emerging-market currencies and stock markets were relatively sanguine about much of this news. A combination of economic growth and easy monetary policy last year handed emerging markets their strongest gains since the recession. The MSCI International Emerging Market Currency Index, which tracks 25 developing-country currencies against the dollar, rose 11% last year and gained another 3.2% in Q1.

But now investors are starting to flee.

Higher US interest rates “finally” pushed the dollar higher and “EM started to crack,” according to Michael Hartnett, the chief investment strategist at Bank of America Merrill Lynch. The Federal Reserve held interest rates unchanged, as expected, at a meeting last week. But it’s expected to hike again next month, and possibly twice more after that in 2018.

“I think the market is now still hopeful for higher rates, okay-performing equity markets, and well-performing emerging markets, but something needs to give at one point,” Stefanie Holtze-Jen, the chief currency strategist at DWS, Deutsche Bank’s asset management arm, told Business Insider on Thursday.

While DWS isn’t throwing in the towel on emerging markets, other investors are more jittery. The MSCI International Emerging Market Currency Index fell last week for a fifth straight period. A similar gauge that tracks developing-market stocks declined for a third week.

As always, there are individual considerations that have worsened the sell-off in emerging markets. For example, Argentina hiked interest rates twice in a day on Friday, to 40%, in a scramble to halt the peso’s decline. S&P Global Ratings downgraded Turkey’s debt rating to junk last week amid the nation’s rising inflation and debt.

Also, it may be too soon to declare victory on the dollar’s comeback. After all, it is still down nearly 6% from a year ago against other G10 currencies.

But if US interest rates and yields truly are headed higher, the dollar would benefit, and there may be more pain ahead for the other sides of the trade.

“If there’s so much momentum going around yield story and inflation, then I’m surprised there’s not a domino falling around everywhere else,” Holtze-Jen said. “In our portfolios, we will be careful.”

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