Emerging markets are rapidly becoming the number one trade for 2016. Both emerging market equity and debt funds have seen record inflows during the past few weeks, and the MSCI Emerging Markets Index is up by around 25% since the January lows, outpacing the S&P 500 by 8.7% over the same period.

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Analysts at UBS pointed out earlier this week that the only other time emerging markets have printed such a broad-based rally in recent history was after the collapse of Long-Term Capital Management in September 1998. Emerging markets rose by 31% in the two months after the September collapse and by 120% by March 2000 after the Federal Reserve bailed out the struggling hedge fund.

The sudden demand for emerging market assets comes despite the political and economic volatility within many of the nations in the emerging market basket. In the past few days, Turkey’s Borsa Istanbul 100 Index has recorded its worst week since 2008 after the country’s coup. Indonesian stocks fell after the country’s central bank unexpectedly held interest rates unchanged while the South African rand rose more than 1% after policymakers decided to leave interest rates unchanged despite the country’s deteriorating economic outlook.

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Despite these developments, investors are still attracted to emerging markets. According to Bloomberg, Goldman Sachs has attracted more than $18 billion into developing-nation assets in the past month and according to the Financial Times, which cites data from EPFR, the last two weeks saw record inflows into emerging market bond funds.

Emerging markets could rally another 20% but….

Technical analysts at CLSA believe that emerging markets can rally a lot further before becoming overbought, implying that the recent rally isn’t over yet. Indeed, according to CLSA’s global technical analysts, Lawrence Balanco and Jonathan Estrada, the MSCI Emerging Market Index broke out of its 12-month basing pattern last week which, “supports an upside target of 1,040- 1,050, some 20% higher.” The duo continue “this week we now have the relative ratio of the MSCI Emerging Market versus the MSCI World breaking out of the six-year downtrend channel, which has unfolded off the October-2010 highs as well as a 12-month basing pattern.”

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However, while the technical picture for emerging markets may support further upside, the fundamental picture continues to deteriorate. In fact, emerging market fundamentals have been deteriorating for the past few years, a trend that explains the six-year downtrend channel mentioned above.

The recent rally in emerging market equities can be attributed to multiple expansion. According to UBS the MSCI Emerging Markets Index now trades at a forward earnings multiple of 12.3, which is only 3% off its five-year valuation high of 12.7 times forward earnings reached in April 2015. The long-term averages 10.9.

Emerging markets could rally another 20% but....
Emerging markets could rally another 20% but….

The 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%)…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%.”

While UBS is concerned about valuation, Credit rating agency Moody’s is worried about emerging market debt. On Tuesday the rating agency warned that many emerging countries’ debt is now growing faster than their economies, leaving them vulnerable to external shocks:

“Total emerging and frontier market external debt ? defined as debt owed by residents of a country to non-residents ? has almost tripled from $3 trillion in 2005 to $8.2 trillion at the end of 2015…Since 2005, private sector external debt has grown at an annual rate of 14.3% compared to 5.9% growth rate for public sector debt.”

So, despite the optimism of CLSA’s technical analysts, the outlook for emerging markets may not be as bright as many investors believe.