Emerging market equities are partying like it was 1998. According to a research note from UBS today, emerging market equities are up by more than a quarter since their late January low, marking the second biggest rally of the period of major medium term volatility since the emerging market peak in May 2011. The only other time there has been such a dramatic movement in emerging market equities was back in 1998 after the collapse of Long-Term Capital Management in September 1998.

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When LTCM, to prevent a full-blown financial crisis Federal Reserve quickly adopted a very dovish monetary policy and cut interest rates by 75 basis points in just two months. Following this quick action and subsequent bailout of LTCM, emerging markets rose by 31% in the two months after the September collapse and by 120% by March 2000. A weaker dollar also played a role in these gains. The currency lost 11% against a basket of major emerging market currencies following the LTCM episode and Fed easing.

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The key parallel between the late 90s rally in emerging market equities and today’s rally is liquidity, or as UBS points out, the episodes confirm how liquidity is a ‘great healer.’

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Indeed, emerging market equity gains over the past six months haven’t been driven by earnings growth or improving fundamentals. In fact, emerging market earnings have been under pressure for much of the past five years. Instead, the market rally seems to have been driven by multiple expansion and flows into emerging markets as investors fret about the growth outlook the developed markets.

Emerging markets rally but investors should be careful

UBS’s figures show that the MSCI Emerging Markets Index — a proxy for emerging market equities as a whole — now trades at a forward earnings multiple of 12.3 compared to a recent average of 10.9. This high multiple puts the index within 3% of its five-year valuation high of 12.7 times forward earnings reached in April 2015.

Emerging markets rally but investors should be careful
Emerging markets rally but investors should be careful

Although the index is still far below its all-time high multiple of 15.1 times as printed in October 2007, this high multiple is cause for concern, especially when you consider that earnings are dropping across the index. As UBS explains:

“The overall level of trailing EM earnings (in USD) has actually fallen very slightly from the market trough in ate-January to today; therefore, all off the current rally has been accounted for by multiple expansion – a warning-sign for investors. By region, Asian earnings have fallen over this period (-3.2%), while earnings in Latin America have surged by over 13% (Figure 10). Given lower market gains by Asia and stronger gains by Latam in this rally, this implies that the amount of multiple expansion has varied less across regions – from +24% in Asia to +32% in LatAm. Dollar earnings have fallen in half of the sectors since late-January, led by Energy (- 7%) but also in Utilities, Telecoms, IT and Industrials. Overall, combining the path of EPS with market performance, the biggest multiple expansion over this period has been in Energy (+53%), with Health Care’s P/E rising by only 13%.” — UBS on emerging markets

So, while it may look as if emerging markets are back in vogue, investors should be careful before jumping on the bandwagon. It doesn’t look as if the fundamentals support the rally.