Emerging market stocks lag as BIS warns of market fragility

Stocks in developed markets saw another strong rally last week but stocks in emerging markets lost ground.

In the United States, the Standard & Poor’s 500 Index rose 0.4 percent last week to a record high of 2,075.37. Helping to propel US stocks up last week was the employment report on Friday showing that the economy added 321,000 jobs in November, the most since January 2012.

The STOXX Europe 600 Index rose 1.1 percent last week to its highest level in almost seven years. European stocks rose even though the European Central Bank refrained from implementing quantitative easing at its monetary policy meeting on Thursday.

In contrast to the positive performance of stocks in developed markets, stocks in emerging markets fell last week. The MSCI Emerging Markets Index declined 1.9 percent, leaving it 1.7 percent down for the year to date.

Emerging markets could face further headwinds.

In its quarterly review published on Sunday, the Bank for International Settlements noted that with the Federal Reserve ending its quantitative easing, the US dollar has appreciated against most currencies, especially against those of commodity exporters. It warned that if the appreciation of the US dollar persists, it may have a “profound impact” on the global economy, and in particular, on emerging market economies where many firms have large US dollar-denominated liabilities.

The BIS also had a warning for financial markets as a whole. In its review, it noted that while financial markets remain buoyant, the spike in volatility in mid-October “underscore how sensitive markets have become to even small surprises” and “suggests that more than a quantum of fragility underlies the current elevated mood in financial markets”.

Indeed, the lagging performance of emerging markets could be a warning sign for the more buoyant developed markets.

At market tops, weaker stocks are often the first to decline. After investors unload the lower-quality stocks, selling then moves to the higher-quality stocks.

Insofar as emerging market stocks are generally considered of lower quality than developed market stocks, it is not inconceivable that we may have been seeing a market topping action unfolding in recent weeks.