EMERGING MARKETS-Russia leads emerging markets lower after fighting in east Ukraine

LONDON Tue May 27, 2014 6:03am EDT

LONDON May 27 (Reuters) - Russian stocks slumped 2 percent on Tuesday and the rouble fell from four-month highs, leading broad-based emerging market losses as flaring violence in eastern Ukraine took the edge off optimism fuelled by smooth weekend elections.

The Ukraine vote yielded a clear win for confectionary magnate Petro Poroshenko who has promised to seek a meeting with Putin to establish stability in eastern Ukraine. The smooth election also averts the immediate threat of fresh Western sanctions against Russia.

But pro-Russia rebels have captured Donetsk airport in eastern Ukraine, with up to 40 separatists said to have been killed so far in nearly 24 hours of fighting with Ukrainian forces.

Russian stocks fell 2 percent to one-week lows after posting 0.7 percent gains on Monday. The rouble slipped 0.3 percent, hit by heavy selling of stocks and local bonds.

Regis Chatellier, a strategist at Societe Generale, attributed the falls to foreign investors taking advantage of recent gains to shed their holdings.

"Some funds are trying to move out of Russia and they are selling on strength. People have been waiting to get rid of Russia exposure," Chatellier added.

The stock market was also pressured by Russia's second-largest bank VTB, which reported a 98 percent fall in first-quarter net profit, citing a deterioration in the Ukrainian and Russian economies. VTB shares fell 3.7 percent.

But Ukraine's dollar bonds, mostly traded offshore, rallied to six-week highs. London and New York were closed for a holiday on Monday, which meant traders had to wait until Tuesday to price the victory.

"The tail risk - that elections would not go smoothly - is behind us now. The good news is (Russian President Vladimir) Putin seems to be ready to work with the new president ... but in eastern Ukraine we are far from any solution and down the road we cannot rule out a split of the country," Chatellier said.

Elsewhere, the Hungarian forint slipped 0.25 percent to the euro ahead of a central bank meeting that is expected to result in an interest rate cut of around 10 basis points.

Bond yields have fallen to record lows since central bank governor Gyorgy Matolcsy flagged more rate cuts. Inflation was at a record low of -0.1 percent in April.

"There is a high probability of an even further reduction in inflation in May as the effect of the 6.5 percent reduction in household gas prices will be seen," SEB analysts said in a note. "In addition, the forint has strengthened ... since the middle of March. This provides the central bank with manoeuvrability."

Earlier, most Asian markets slipped after weeks of gains.

Investors took profits from the Indian rupee's 5 percent gain this month and Chinese shares slipped as hoped-for policy steps to boost the economy have not yet materialised. Indian stocks also pulled back from record highs as investors booked profits.

All that helped pull MSCI's emerging equity index down half a percent, retreating from last week's 6-1/2 month highs.

But most analysts saw the weakness as a pause given ultra-low interest rates in developed countries and the likelihood of more policy easing in Europe has given a fresh impetus to the carry trade - buying higher-yield overseas assets.

European Central Bank President Mario Draghi hinted on Monday at steps to avert deflation.

"We expect the environment for emerging markets to be constructive. We expect inflows of portfolio investment into EM equities and bonds, boosting local currency asset prices. There are so far no hindrances in sight to dampen the carry trade theme," Credit Agricole said in a note.

For GRAPHIC on emerging market FX performance 2014, see link.reuters.com/jus35t

For GRAPHIC on MSCI emerging index performance 2014, see link.reuters.com/weh36s

For GRAPHIC on MSCI emerging Europe performance 2014, see link.reuters.com/jun28s

For GRAPHIC on MSCI frontier index performance 2014, see link.reuters.com/zyh97s

For CENTRAL EUROPE market report, see

For TURKISH market report, see

For RUSSIAN market report, see ) (Editing by Jane Merrman)

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

Find your dream retirement town

Florida? Hawaii? Reuters has teamed up with Zillow to give you the power to customize a list of your best places to retire.  Video | Full Article