LONDON Aug 28 Emerging stocks retreated from three-year highs on Thursday, with Moscow-listed shares falling the most as reports of Russian military incursions into Ukraine dented hopes for a resolution to the crisis.
The MSCI emerging equities index was down 0.4 percent, while debt insurance costs for Russia and Ukraine both rose to multi-week highs.
Fears of a spiralling conflict on the Russia-Ukraine border have brought emerging markets off highs hit on expectations for further monetary stimulus in the euro zone.
Those expectations were also tempered after sources told Reuters the European Central Bank is unlikely to take new action next week unless inflation figures on Friday show the euro zone sliding significantly towards deflation.
David Hauner, head of Emerging EMEA fixed income and economics at Bank of America Merrill Lynch, said emerging assets were unlikely to see a sharp move lower, with the U.S. Federal Reserve's moves well-telegraphed and little global spillover from the Ukraine conflict.
"As long as you don't get a more hawkish tone from the Fed, the risk for EM is limited," Hauner said.
"The genie is out of the bottle and the market will continue to buy dips in risky assets on the back of the endless expectations of QE from the ECB."
Russia's rouble-denominated MICEX index, however, fell 2.1 percent to two-week lows, while the dollar-based RTS index lost 3.3 percent. The rouble, meanwhile, was 1.3 percent weaker against the dollar, its lowest since March.
Hauner said he was advising clients to stay neutral on Russian assets.
"It's very hard to justify being overweight at this point. Even though from a valuation perspective there could be an argument, you have a huge potential tail risk hanging over your position. The macro case is being totally dominated by geopolitical risk," he added.
A Ukrainian fighter told Reuters on Thursday the strategic port of Novoazovsk had been occupied by regular Russian troops disguised as rebel soldiers, a potentially significant escalation that will fuel rumours of large-scale Russian military intervention.
Russia denies military involvement in Ukraine.
Ukraine's five-year credit default swaps surged to new three-month highs, up 34 basis points from Wednesday's close to trade at 1,016 bps, data from Markit showed. Russian CDS rose 13 bps to two-week highs.
The fears took a heavy toll on Ukrainian dollar bonds, with its portion of the EMBI Global bond index widening 14 basis points (bps) on the day to 895 bps over U.S. Treasuries.
Ukraine's sovereign dollar bonds due in 2017 and 2020 fell more than one cent each, while the hryvnia slipped 0.7 percent to bid at 13.5 per dollar, approaching the record low hit on Wednesday.
Analysts at JPMorgan said they had moved Ukrainian and Russian sovereign bonds to underweight in their model portfolio.
"Recent optimism around a negotiated solution to the crisis as reflected in market pricing appears overdone in our view," the bank told clients.
Emerging European stocks also weakened on Thursday, tracking Western Europe's bourses.
Budapest lost 1.5 percent while on currencies, the Polish zloty, the most liquid regional unit and often a proxy for the rest of central Europe, slipped 0.4 percent versus the euro. It is also weighed down by rate cut expectations.
"We see uncertainty in the market caused by the exacerbating situation in Ukraine. Investors are closing their positions ... in order to minimize the risk," said a currency dealer at a major bank in Warsaw.
The Turkish lira was 0.8 percent weaker against the dollar a day after the central bank unexpectedly lowered its overnight lending rate.
Saudi and Qatari stocks fell as investors booked profits after strong gains this week.
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 (Additional reporting by Sujata Rao; Editing by Hugh Lawson)