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Emerging-market stocks are off to a roaring start to the year, but investors might want to take some profits after the big move up, according to Credit Suisse.
Andrew Garthwaite, the bank's head of global equity strategy, reduced his overweight rating on emerging markets to 7 percent from 12 percent. He cited several factors, including an expected rebound in China, complacency around U.S.-China trade negotiations and broad optimism in emerging markets.
"On our model, we see only 2% outperformance on our base case, but 11% underperformance in the risk scenario," Garthwaite said in a note Wednesday.
The iShares MSCI Emerging Markets ETF (EEM) is up 8.6 percent through Tuesday's close. Last year, EEM fell 17.1 percent to notch its biggest annual decline since 2015.
Recent data out of China, the largest economy within emerging markets, has been soft. The purchasing managers' index tracking China's services sector has slowed since December, while the index gauging China's key manufacturing sector indicated a contraction to start off 2019. China's economy also grew at its slowest pace in nearly three decades in 2018.
This slowdown increased expectations that Chinese authorities will intervene and China's economy will regain its footing. However, "there has been only a limited policy response so far to turn around growth," Garthwaite wrote. He also said a recovery in China is "largely discounted" at this point.
On the trade front, expectations that China and the U.S. will reach a deal have grown so much that investors are now complacent, Garthwaite said. "Hence, the market seems vulnerable in the event of a disappointing outcome in the trade negotiations."
Trade negotiations between the two countries are continuing this week in Washington. Both countries have until early March to come up with a deal. Otherwise, additional U.S. tariffs on Chinese goods could be implemented. However, President Donald Trump said Tuesday the March deadline was not a "magical date."
Lastly, Garthwaite says the long emerging-markets trade may be getting crowded as optimism in the space has surged. An investor survey conducted by Credit Suisse in February showed global emerging markets was the most popular region among investors over a three-month period.
Still, the strategist maintains his overweight rating as the dollar will likely weaken this year and the "perfect storm of macro headwinds" for emerging markets is fading, saying:
In 2018, emerging markets faced a perfect storm of a stronger US dollar, rising TIPS yields, falling China PMIs and the escalating trade war. From here, such a negative combination is unlikely to repeat itself. On our central scenario, there should be no further deterioration in China, the dollar should weaken modestly and the TIPS yield should stay flat.