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Emerging market rally to run out of steam: Morgan Stanley

Frank van den Bergh | E+ | Getty Images

After last year's rout, emerging markets have charged ahead recently, but Morgan Stanley expects the rally will run out of steam as soon as earnings season strikes.

"Don't chase the rally," Morgan Stanley said in a note dated Wednesday. "We don't see top-down or bottom-up catalysts." It noted the MSCI Emerging Markets index's around 10 percent rally since early February means it's now nearing its 12-month target of 1050. The index ended at 1009.22 on Thursday.

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"The catalyst for the rally has been the ending of an unprecedented period of fund outflows from the asset class (22 weeks, 7 percent of assets under management) rather than an improvement in fundamentals," it said, although it noted some "idiosyncratic" positives such as the improvement in India's current account position.

Over the three weeks to April 9, around $4.8 billion has flowed into emerging market equity funds, while the segment's bond funds have seen around $2.85 billion in inflows over the two weeks to April 9, according to data from Jefferies

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But fund flows so far this year are still negative, with bond funds shedding $9.33 billion and $25.55 billion fleeing equity funds year to date, the Jefferies data show. This followed a tough 2013, which saw $14.1 billion exit emerging market equity funds, while $14.04 billion said good-bye to the segment's bond funds, according to data from Barclays.

Fund managers are also turning less negative on emerging markets, with a net 13 percent taking underweight positions on the segment, down from March's 31 percent, according to the Bank of America-Merrill Lynch fund manager survey.

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But Morgan Stanley doesn't expect a sustainable turnaround for emerging market sentiment.

"The upcoming earnings season is probably the catalyst for the end of the recent rally," it said.

Emerging markets' upcoming earnings reports are likely to miss consensus estimates, which would mark the ninth quarterly miss out of the past 11 quarters, the bank said. It noted its 12-month forward earnings per share forecast for the index in $92, while the consensus expects $96.

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In addition, from a macro perspective, Morgan Stanley expects continuing strength in U.S. data and rising U.S. bond yields will spur U.S. dollar strength, pushing down emerging market currencies through the third quarter. It also expects most emerging markets will see their gross domestic product (GDP) growth slow on a quarter-on-quarter basis this year, with only developed market-focused economies, such as South Korea, Taiwan and Mexico, likely to be significant exceptions.

Emerging markets have seen a brutal sell-off earlier this year and last year after sharp falls in the value of the Argentine peso, Turkish lira, South African rand and Brazilian real triggered panic selling across the asset class, with analysts largely blaming the turbulence on the Federal Reserve's move to begin tapering its asset purchases.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1