Emerging Market Turbulence to Continue

FX Quarterly_EM cover image

  • The Fed has embarked on its first tightening cycle since 2004-2006. With the pace and the terminal rate still unknown, we think a sustainable EM rally will remain elusive.
  • We could see EM get some limited traction in late 2016 if the Fed is successful in calming markets after it starts tightening. Coupled with the ECB and BOJ QE programs seen continuing well into 2017, EM yields should eventually prove to be attractive.
  • The renewed slide in commodity prices is worrisome for exporters, but will help importers.
  • For all EM asset classes, we continue to see fundamental divergences across countries. As such, we recommend that investors continue to differentiate.

With the Federal Reserve lift-off commencing, we believe the outlook for Emerging Markets (EM) remains negative in the upcoming quarter. The investment climate suggests that the boom days for EM are over. As we have noted for most of this past year, the major factors behind the decade-long EM rally show little sign of returning anytime soon. Past Fed tightening cycles have proven very disruptive for EM, and we see no reason why this shouldn’t be the case this time, especially given broadly deteriorating EM fundamentals. We see many EM currencies trading at new multi-year and/or all-time lows in 2016.

We could see EM get some limited traction in late 2016 if the Fed is successful in calming markets after it starts tightening. The Fed is widely expected to tighten at a very modest pace and ending at a lower than “normal” terminal rate. With the European Central Bank (ECB) and Bank of Japan (BOJ) QE programs seen continuing well into 2017, EM yields should eventually prove to be attractive. But we’re not there yet.

The ratings outlook for EM remains largely negative. S&P’s downgrade of Brazil to sub-investment grade last quarter sent a strong signal that the agencies won’t hesitate to cut investment grade countries. Moody’s is likely to follow suit soon after placing Brazil’s Baa3 rating on review for possible downgrade. Elsewhere, South Africa is now on the cusp after S&P cut the outlook on its BBB- rating from stable to negative. Moody’s recently affirmed its Baa3 rating for Turkey but maintained its negative outlook. Our own sovereign ratings model shows all three of these countries as sub-investment grade, and we look for downgrades in 2016. This should keep market sentiment negative on EM.

China continues to slow, and will likely result in soft global demand for commodities. However, we continue to believe that China will muddle through. Further People’s Bank of China (PBOC) stimulus is likely in the coming months. We do not expect any sort of devaluation efforts from China, though the yuan is likely to weaken along with the rest of EM given the greater role of market forces introduced into the CNY fix.

On the other hand, supply considerations continue to weigh on commodity prices too. With the seeming abandonment of its quota system at the December OPEC meeting, it appears that oil will likely continue testing the downside. For copper, new mines in Peru are scheduled to come on line in 2016, further weighing on prices. A similar story may unfold for iron ore, with Rio Tinto reportedly planning to expand operations at its mine in Western Australia despite multi-year lows in prices.

Frontier African economies are likely to remain under significant pressure. Like Latin America, this region benefited greatly from the China-related commodity boom. Now that the boom is over, frontier Africa is facing the same headwinds as Latin America, but without the benefit of having strong institutional frameworks or policymaking expertise.

Equity markets are in the midst of a tug of war between opposing forces. On the one side, rising US interest rates and slow global growth argues for lower equities. On the other side, continued QE from the ECB and BOJ should offer some limited support for equities even as the Fed starts lift-off. At some point in 2016, we think EM equity valuations (as well as exchange rates) will cheapen enough for some value investors to start some modest rebuilding of long positions in EM.

For all EM asset classes, we continue to see divergences across countries. As such, we recommend that investors continue to differentiate. While we remain largely negative on EM, some countries will fare better than others in this environment. Asia should outperform, while Latin America should underperform. EMEA is seen somewhere in between but closer to Asia.

 

FX Quarterly_RussiaThe Russian economy may be bottoming out as Q3 GDP contracted -4.1% y/y, better than the previous quarter (-4.6% y/y) and the market consensus. Industrial production continues to improve and inflation pressures have started to ease from base effects. However, deteriorating external conditions should continue to weigh on fundamentals. Oil prices have continued to drop, worsening the economic and fiscal outlook. The fiscal deficit is expected to rise to nearly -3.5% of GDP this year from less than -1% the past three years, and 2016 should see further deterioration that leads to higher downgrade risk.

An array of sanctions against Turkey also increases a risk of worsening Russian fundamentals. Russia banned a range of Turkish food imports and is curbing travel in retaliation for the downing of a bomber on the Syrian border. The fruit and vegetables imported from Turkey have large market shares in Russia, and the sanctions could push inflation higher. The central bank has kept rates steady at 11.0% since the last 50 bp cut in July. We think steady policy is the right decision in light of rising inflation and the weak ruble. The central bank suggested that easing could be seen in 2016 if the inflation trajectory improves as it expects. However, the bank recently admitted that inflation remains higher than it expected.

 

FX Quarterly_Brazil

Brazil’s economy has spiraled downward due to both external factors and shrinking domestic demands. Brazilian firms continue to decrease investment and employment. Private consumption remains weak on the deteriorating labor market and persistent high inflation. The government cannot afford to expand fiscal expenditure due to risks of further downgrades to sub-investment grade. Fitch downgraded Brazil to the lowest level of investment grade BBB- with negative outlook, while Moody’s placed its Baa3 rating on review for possible downgrade. BBH’s sovereign rating model now sees Brazil at BB-/Ba3/BB-, down from BB+/Ba1/BB+ last quarter. We think that Brazil will lose its investment grade rating from another rating agency over the course of the next 2-3 months.

The central bank continues to keep rates steady at 14.25%, a nine year high. However, a hawkish dissent appeared at the last Comitê de Política Monetária (COPOM) meeting, and with inflation still rising, we think the tightening cycle could resume in 2016.

Brazil’s Congress began convening an impeachment committee, putting intense focus on whether President Rousseff’s main coalition partner will remain loyal or take the opportunity to bring her down. We do not view impeachment as a bullish development, as it will further delay the needed economic and fiscal adjustments.

 

FX Quarterly_Mexico

Mexico finds itself in the familiar position of coming under strong selling pressure despite good fundamentals. Yes, lower oil prices are a problem for the economy, but manufactured exports to the US have taken up some of the slack. GDP is expected to grow 2.3% this year and 2.8% next year. Domestic consumption remains robust, but has yet to feed into rising price pressures. Indeed, inflation continues to fall to all-time lows and does not make a compelling case for aggressive tightening by Banco de Mexico.

The weak peso ultimately pushed the central bank into starting the tightening cycle. While there has not yet been any inflationary pass-through from a weak peso, the bank decided to be cautious and hike rates in order to anchor inflation expectations. Elsewhere, the budget deficit has deteriorated a bit from low oil prices and slow growth, but remains manageable. So too is the current account deficit. Amongst the major commodity producers in EM, we believe Mexico is one of the best-positioned in terms of policy and fundamentals.

Yet the peso continues to make all-time lows against the dollar. Why? Because the peso typically suffers in bad times due to its role as a proxy for wider EM. The peso is freely tradable (and shortable), and so investors that are negative on Brazil or Russia can more easily express their views via the peso.

 

FX Quarterly_South Africa

The country continues to grapple with slow growth, high inflation, high unemployment, and rising downgrade risks. Now add heightened political risk to the mix. The recent firing of Finance Minister Nene was a real blow to investor confidence, as it signals that President Zuma was unhappy with efforts to tighten fiscal policy. Financial markets reacted negatively to Nene’s replacement (a little-known ANZ lawmaker), and so he in turn was replaced by former Finance Minister Gordhan. While this is a welcome move, investor confidence will be hard to regain.

The South Africa Reserve Bank (SARB) recently hiked rates to 6.25%, the highest since August 2010. Inflation expectations remain very high, near the upper end of the range. The weak rand, rising electricity costs, and severe drought worsen inflation risk. We think that the tightening cycle by the SARB will continue. While there may not seem to be much urgency to hike again given the economic situation, the recent collapse in the rand may force the central bank’s hand into tightening more aggressively.

The twin deficits are not expected to improve near-term. The current account deficit was -4.1% of GDP in Q3, worse than -3.1% in Q2. The YTD fiscal deficit rose to ZAR147.72 bln in October, bigger than 2014’s total. Ratings downgrades to sub-investment grade are becoming more likely in light of the worsening debt and deficit trajectories in 2016, especially with risks of even bigger budget shortfalls ahead. We are not sure how much leeway Zuma will give Gordhan to tighten fiscal policy in the coming months.

 

FX Quarterly_Poland

In the general election in October, the new right wing opposition Law and Justice won a strong majority. The new government has said it will try to spur investment and innovation, and increase social spending by reversing the recent increase in the retirement age and boosting the monthly child subsidy for poor households. However, these policies will put upwards pressure on the budget deficit. Indeed, estimates suggest the planned measures could raise the fiscal deficit by PLN3-4 bln more than planned. The budget deficit is expected to come in under -3% of GDP in 2015 for the first time since 2007, but there is a risk that this gap will rise in 2016 under the new government.

Popular protests have already been seen in response to what some see as efforts to limit democracy. The Law & Justice government has already forced out the head of the anti-corruption agency, limited opposition oversight of the intelligence services, and outlined plans to overhaul public media. These measures have raised concerns that Poland is moving towards a Hungarian-style of autocratic governing.

The economy remains robust, however. GDP growth was 3.5% y/y in Q3, near the top of recent ranges. Unemployment fell to 9.6% in October, the lowest since December 2008. Retail sales remain strong, helping to offset the drag from weak exports.

On the other hand, deflation risks persist as CPI came in at -0.5% y/y in November. Poland has posted y/y deflation since July 2014, which suggests further easing may be seen ahead. Rate cuts are unlikely until early 2016, however, when virtually the entire Monetary Policy Council (MPC) will be replaced as their terms expire in Q1. We suspect the new government will nominate pro-growth dovish candidates for the MPC.

 

FX Quarterly_China

While China’s data has shown some signs of stabilizing, we expect further slowing as part of a secular transition towards a domestic consumption- led growth model. The International Monetary Fund (IMF) sees 6.8% growth this year, 6.3% in 2016, and 6% in 2017. Exports continue to contract y/y, while retail sales remain robust and growing above 11% y/y. Bank lending has picked up in response to previous People’s Bank of China (PBOC) easing, and we expect further monetary stimulus in 2016.

We also expect further CNY weakness in the coming year, but we stress that this reflects wider EM weakness and the increased role for markets in determining the exchange rate. Any sort of maxi-devaluation is unlikely, and we view recent efforts by the PBOC to move market focus to a CNY basket (and away from the bilateral USD rate) as relatively benign. Inclusion of the yuan in the SDR basket is unlikely to have a significant impact on the exchange rate.

While we do not think China is headed for a hard landing, the ongoing soft landing has implications for global investors. First and foremost, softer China demand for commodities, coupled with increased supply globally, is likely to keep downward pressure on commodity prices.

 

FX Quarterly_India

The Indian economy remains robust as Q3 GDP grew at 7.4% y/y, higher than 7.0% y/y in Q2. Private consumption should continue to firm and business investment has accelerated. The current account deficit continues to shrink and inflation pressures remains contained, due in part to lower oil prices. Furthermore, oil prices at these levels are very favorable for the country’s external accounts.

The Reserve Bank of India (RBI) suggests more easing will be seen in order to support growth, but the room to ease is narrowing as additional easing may weigh heavily on the rupee. Also, CPI inflation is creeping higher toward the top end of its 2-6% target range and so the RBI may have to be more cautious. Still, Rajan at the helm of the central bank will continue to be a solid anchor for the country’s macroeconomic management and banking sector reform.

The ruling Bharatiya Janata Party (BJP) was defeated in the Bihar state assembly elections, which many considered to be a referendum of sorts on Modi’s first 17 months in power. The poor results will likely move Modi to soften up his tone, even as the Goods and Service Tax (GST) and other deregulation measures will be blocked by the opposition in the Upper House. Modi will have to spend more time and energy on campaigning and less on pushing economic reforms. It also may mean that he will have to refocus his priorities towards addressing social tensions.

 

FX Quarterly_South Korea

The Korean economy has stabilized as Q3 GDP rose 2.7% y/y. Private consumption accelerated to 2.1% y/y, the highest since 1Q 2014, but exports have weakened due in part to slower China growth. Fiscal stimulus by the government has supported growth. However, there is still a risk that the economy will slow again as weak global growth will limit Korean exports, which consists of around 50% of GDP.

Headline CPI has been benign, rising 1.0% y/y in November and well below the 2.5-3.5% target range. This is due in large part to lower oil prices, as core CPI remains elevated at 2.4% y/y. The Bank of Korea (BOK) has kept rates steady since June, when it cut rates by 25 bp to 1.5%. Effects of fiscal stimulus will likely be gauged by the BOK before it acts again. We think the bank will cut rates further in 2016 if the data remain soft.

 

FX Quarterly_Indonesia

Bank Indonesia (BI) recently cut the reserve requirement for lenders to 7.50% from 8.00% while keeping the policy rate steady at 7.50% since March 2015. BI has taken other macro prudential measures this year to help boost lending, so the easing bias is in place. Inflation eased to 4.89% in November, the slowest since October 2014 and within the bank’s target range between 3-5%. Disinflation should continue, though a weaker rupiah will likely lead to some pass-through into inflation ahead. Under improved macro conditions, the bank is looking for room to cut rates.

President Jokowi is struggling to revive growth amidst declining demand for the country’s commodities, stagnating foreign investment, and slower domestic consumption. The government’s latest package of measures aimed at improving the business climate included tax holidays of up to 25 years for companies establishing businesses in one of eight economic zones dotted around the archipelago.

GDP growth in Q3 2015 was at 4.7% y/y, the same as Q2. Still, Indonesia fundamentals have improved despite a sluggish economy. Its current account deficit continues to shrink to below 2% of GDP. However, the rupiah is likely to remain vulnerable to the stronger dollar, and will depend in large part on foreign inflow. Foreign reserves have been falling steadily, while S&P recently noted that Indonesia is very vulnerable to capital flight.