Why One Trader Thinks Emerging Markets Are About To Get Slammed

While so far the rout from the North Korea crisis has impacted global volatility first and foremost, with the VIX surging 50% (a rather pointless metric considering where the VIX was just days ago) on a modest drop in the S&P which earlier this week was making new all time highs, as massive short vol positions have been rapidly unwound, one trader believes the next place of impact is the sector which has so far emerged, so to say, largely unscathed from rising risk concerns: emerging markets, the clear outperformer so far in 2017.

In his latest overnight Macro View, Bloomberg's Mark Cudmore writes that "Rightly or Wrongly, EM to Bear the Brunt of Selloff", and considering the overnight plunge in Chinese stocks, which as discussed earlier just suffered their biggest drop of the year led by the commodity sector...

... he may be right.

His full note below.

Rightly or Wrongly, EM to Bear the Brunt of Selloff

During acute periods of risk-aversion, positioning dominates fundamentals. This is why some of the best structural investment stories can see the most painful corrections in the short-term. 

Emerging-market assets have been the rampant outperformers of 2017. The macro fundamental arguments for the vast majority of these assets remain in place: solid growth, high real yields, very cheap currencies, great demographics, an exploding middle- class, and exposure to a booming Chinese economy.

These are all long-term factors though and they provide little protection in a financial asset storm. Investors’ focus becomes dominated by risk-management and the profit-and-loss bottom line. Everything else is secondary.

The VIX has bounced to the level where it topped out in both April and May. Does that imply this current risk-aversion is almost over already? Not likely. Precisely because investors have been trained by the market resilience to not panic nor aggressively reduce exposure during corrections -- and that’s the reason they’ll be playing catch-up this time.

That lesson, to pause before reacting, has been particularly clear in EM, where the cost of chopping and churning is more expensive due to lower liquidity and wider bid-ask spreads.

EM market financial supports are being taken out left, right and center. Global equity markets, credit markets and even commodities are now getting hit. If that wasn’t doing enough damage to reduce risk appetite, the heightened prospect of a nuclear exchange will be in all the weekend papers.

For the two decades up to and including 2016, every single calendar year brought at least a 10% correction in the MSCI Emerging Markets Index. Why would 2017 be any different, especially when there are real reasons to worry?

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