The opinions expressed here are those of the author, a columnist for Reuters.

By Jamie McGeever

ORLANDO, Florida, May 6 (Reuters) - Emerging market stocks are smashing record highs and bond spreads are the tightest in years - despite the biggest energy supply shock in history. The question is how long this can last.

Emerging markets sold off strongly in March, with EM equities recording their biggest outflow in more than 20 years, according to the Institute of International Finance. That rout has since given way to an even stronger rally, revealing a resilience many observers probably never thought possible.

The MSCI global emerging market index .MSCIEF and MSCI Asia ex-Japan index <.MIAPJ0000PUS> both climbed 3% to new record highs on Wednesday, meaning they are each more than 20% above their March 31 lows.

Over in fixed income, yields are rising on government debt, but the JPMorgan EMBI spread between emerging-market dollar debt and U.S. Treasuries is back to pre-Iran war levels and close to the tightest levels since 2013.

The recovery in corporate bond spreads is even more remarkable. JPMorgan's CEMBI index yield spread versus Treasuries is tighter than it was before the war began, and on Tuesday traded at 205 basis points, the narrowest since August 2007.

Of course, asset prices in those countries most exposed to the energy squeeze have underperformed, with some notable weakness in currencies. But there is no market panic.

Yet the growth, inflation, and policy outlook for the rest of this year is far from serene, even if the Middle East conflict subsides. The fiscal outlook in many countries is deteriorating.

The International Monetary Fund has revised down emerging and developing economies' growth this year by a mere 0.3 percentage point, but that masks a high degree of dispersion under the surface.

Indeed, authorities in those economies most vulnerable to soaring fuel, fertilizer and transport costs have already had to take action to cool domestic price pressures and ease the burden on households.

And in a more adverse scenario in the Middle East, the IMF warns, the impact on emerging economies will be almost twice that on advanced economies. Markets may be sanguine today on news of a potential framework for a deal to end the war and reopen the Strait of Hormuz, but we've been here before with no permanent resolution.

Uncertainty remains unusually high, but EM investors are unusually calm. What gives?

CALM OR COMPLACENT?

The wave of hyper-optimism around the artificial intelligence investment boom is clearly a factor. Stock markets in Taiwan and South Korea, two countries going into overdrive to meet U.S. hyperscalers' insatiable demand for semiconductors, are up 30% and 45%, respectively, in the last six weeks.

Investors may also be taking comfort in the fact that EM inflation hasn't spiked nearly as much as it did during the last energy shock in 2021-22 when global supply chains were snarled during the pandemic lockdowns and Russia's invasion of Ukraine.

Annual emerging market inflation, excluding China, was 3.5% in March, according to Citi economists, the highest in over a year, but still well below the peak of 8% in 2022.

However, this complacency could prove dangerous. This wave of rising oil prices has been much bigger than what we saw in 2022, so EM inflation is likely to keep moving up.

Similarly, a 20%-plus rise in global food prices in the coming months, as economists at HSBC predict, is well below the near-80% rise in 2022, and food prices would still be lower in inflation-adjusted terms. But food is a much greater share of consumer spending in EM countries, and the pain is only starting to filter through the system.

DANGEROUS OR DELICATE?

Ultimately, asset prices often take their cue from financial conditions. Emerging market financial conditions tightened after war broke out on February 28, with Goldman Sachs' global EM financial conditions index rising as much as 100 basis points in March. That has since eased considerably, and is nowhere near as severe as the 350 basis-point spike that followed the Russian invasion in February 2022.

The tightening has mainly been kept in check by exchange rate depreciation that has swept across the emerging world.

India's rupee, Indonesia's rupiah and the Philippine peso have slumped to record lows, and most emerging currencies have depreciated to some extent since the war started.

All else being equal, a weaker currency helps support export-led growth and cheapens domestic assets for dollar-rich foreign investors.

Of course, a tumbling currency comes with its own risks - namely higher imported inflation. A rapid pick-up in price increases could easily spook foreign investors, creating a vicious cycle.

But, for now, low exchange rates are helping to prevent EM financial conditions from tightening too much and supporting asset prices. It's a delicate dance. It may be a dangerous one as well.

(The opinions expressed here are those of the author, a columnist for Reuters)

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