(This version of the Feb. 5 story was corrected to clarify GMO forecast in paragraph 10 for emerging market ‘value’ stocks not just emerging market stocks)
By Rodrigo Campos
NEW YORK (Reuters) - Emerging markets stocks are so far weathering the storm in developed markets stocks and bonds in the past few days, though action in U.S. markets in the next few days may test investor appetite for the asset class.
Asian stock markets are expected to be pressured lower on Tuesday after the U.S. benchmark S&P 500 stock index .SPX fell 4.1 percent on Monday, its largest daily percentage drop in 6-1/2 years.
By contrast the MSCI index of emerging market stocks .MSCIEF fell only 1.75 percent, the largest drop in just over two months.
Most of the weakness in equities is expected to remain contained in U.S. markets, as investors change asset allocations due in part to a stronger than expected string of economic data.
U.S. economic growth was running at an annualized 2.6 percent in the fourth quarter of last year, and on Friday the U.S. Labor Department reported the unemployment rate at a 17-year low of 4.1 percent, but wages saw their largest rise in more than eight years.
Friday’s data revived fears of inflation and a faster pace of Federal Reserve interest rate increases this year, pushing up U.S. benchmark bond yields to four year highs.
“The reason for the (U.S. stocks) selloff is because things are better than people thought and they want to reevaluate allocations between equities and bonds,” said Erin Gibbs, equity chief investment officer at S&P Global Market Intelligence in New York.
The relatively mild response in emerging markets speaks to traders confidence that the U.S. decline is a correction to stretched equity valuations rather than weakness in economic growth, corporate earnings or financial system strains, analysts said.
“Over the last year we’ve been adding to emerging market value stocks, which is an asset class that is far more attractive than anything else we can find,” said Catherine LeGraw, a member of the asset allocation team at Boston-based asset manger GMO.
LeGraw said GMO forecasts emerging market value stocks will gain about 6 percent annualized after inflation over the next seven years, a gain that “no other asset class comes close” to matching.
However, Monday data from the Institute of International Finance (IIF) show outflows from emerging market portfolios were the highest since the U.S. presidential election in November 2016, with bonds being hit less hard than equities.
And the current selloff in U.S. equities may not have run its course yet.
“Asia will follow in sympathy of what they saw in New York because the trigger of the selloff is a New York event,” said Claudio Irigoyen, the New York-based head of Latin America economics and fixed income strategy at Bank of America Merrill Lynch.
The key, he said, lies in the U.S. Treasury debt market. U.S. Treasury yields fell on Monday, as the stocks selloff sparked demand for the low-risk debt, after yields hit four-year highs on Friday.
Upward pressure on U.S. yields may not be over though as the Treasury is due to significantly increase its borrowing this year to make up for declining purchases from the U.S. central bank and to fund a fiscal deficit widening as a result of the Trump administration’s tax cuts late last year.
“If you’re still having more of a rally in yields between now and tomorrow’s (stocks) open, that may lead people to think there’s more of a correction to come in equities,” Irigoyen said.
“If yields stabilize people may be more willing to buy the dip in U.S. equities tomorrow,” this would help underpin emerging equities, he said.
Reporting by Rodrigo Campos, additional reporting by David Randall; Editing by Daniel Bases and Clive McKeef