EM exuberance is back

And once again, investors are bullish on emerging markets.

With the Fed on pause and trade tensions between the US and China ebbing, investors have been quick to forget the crises that hobbled emerging markets last year. But with investor sentiment shifting closer to "exuberance," as one strategist puts it, and sources for further upside waning, the tide could soon turn against those who have been over-eager allocating money to emerging markets this year.

After a trying 2018, investors have poured billions into hard currency emerging market deb since January, with ten consecutive weeks of positive inflows, according to EPFR Global. Interest in the local currency denominated fixed income has lagged, but the swift uptick in hard currency debt has more than made up for it.

Here's a chart from Citi's James Barry showing the surge:

Sentiment has shifted a notch higher as well, approaching "exuberance" territory, according to David Hauner at Bank of American Merrill Lynch. To reach this conclusion, Hauner uses the firm's EM Carry Sentiment Indicator, which tracks investor bullishness and bearishness, and a Bloomberg index tracking carry-trade returns from eight emerging markets (a popular carry trade is when investors borrow in dollars to buy higher yielding emerging market assets).

As the chart below shows, the EM Carry Sentiment Indicator has surpassed 80 (the light blue shaded area corresponding with the right-hand y-axis), while the Bloomberg EM carry index (the dark blue line corresponding with the left-hand y-axis) has bounced back from last year's lows:

A reading of 90 or higher means the "exuberance" threshold has been crossed, a level that historically precedes sell-offs. Despite this worrisome milestone, investors across Europe and the US surveyed by Hauner and his team seem unperturbed. The 80 or so investors the BofA strategists spoke to were "universally bullish," and a recent BofA fund manager survey found "long EM" to be the most crowded trade.

That may soon change, however, because as Hauner points out, most of the good news bolstering the bullish case for emerging markets — namely the stabilising economic situation in China, the trade war stand-down, and the Fed's dovish tilt — has already been priced in.

This reality is already cropping up in emerging market sovereign credit spreads. While they have tightened some 45 basis points so far this year, with emerging market returns closing in on 5 per cent, the pace has slowed this month. Total returns have fallen to just 0.5 per cent since February, and spread compression has stalled, with those for frontier markets actually widening.

Here's a chart from Nafez Zouk of Oxford Economics showing this dynamic for emerging market debt, JPMorgan's Emerging Market Bond Index ex-Venezuela and frontier markets:

What's needed to propel emerging markets further following the Fed's rate-hike pause is brighter growth prospects globally.

While Chinese officials have shown a willingness to pull monetary and fiscal levers to stimulate the economy, the growth situation there appears tenuous at best. In fact, analysts reckon growth in the People's Republic will remain under pressure for many more months. A slower expansion will hamstring the government's deleveraging efforts, so sky-high debt levels will continue to weigh on the country's outlook. And in Europe, the doom-and-gloom is so dire that this month ECB president Mario Draghi had to again revive stimulus measures that the central bank had removed just two years prior.

When's infrastructure week again?