Emerging markets – What will sour sweet spot?

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Emerging market (EM) asset prices have performed well since the UK referendum on 23rd June. The overall driver is the perceived view that the risk-reward of investing in EM has improved, both due to better relative returns and more limited risks.

Major developed central banks’ willingness to keep monetary policy loose to put a floor under economic growth is central to this improved risk-reward trade-off for EM assets.

Near-zero rates in most developed markets have put in high-relief high-carry currencies such as the BRL and ZAR which are also benefiting from high global metals prices.

On the risk side of the equation, slowing rather than collapsing global growth and higher commodity prices have attenuated concerns about EM economies’ ability to prosper.

Moreover, stable and still significant EM central bank FX reserves have dulled fears about their ability to defend their currencies in the event of an endogenous or external shock.

At the same time, acute economic, political and geo-political risks in developed economies has led markets to revisit the perceived notion that emerging countries’ economies and political set-ups are inherently less stable and more risky.

Put differently, developed market economies remain just about strong enough to drive EM growth but are sufficiently weak and susceptible to endogenous shocks to highlight the attractiveness of EM assets. The question is what, if anything, is likely to destabilise this fine balance.

The two events which have seriously rattled EM assets, including currencies, in the past year had their epicentres in the world’s two largest economies: the PBoC’s renminbi “devaluation” in August and subsequent government tinkering with Chinese equity markets and the US Fed’s first hike in a decade on 16th December.

An EM crisis is still more likely to have its birthplace in the US or China than Europe for example, in my view, with EM asset prices in the past 18 months relatively resilient to made-in-Europe stresses.

US GDP growth remains unspectacular, with the manufacturing sector weighed down by a strong dollar, while China’s economy is still dependent on loose credit policy and vulnerable because of banks’ growing non-performing loans.

While both the Fed and Chinese policy-makers have seemingly learnt lessons from prior misjudgements, in both countries the risk of policy mistakes remains very much alive. Moreover, the US presidential elections scheduled for 8th November present a significant event-risk to emerging markets and their currencies.

Much has been made of the resilience of emerging markets (EM) in the wake of the UK referendum on 23rd June. There have been sizeable flows from developed to EM equity and bond funds, EM equities are up about 5.5% and a GDP-weighted basket of EM nominal effective exchange rates (NEERs), excluding the Chinese Renminbi, has appreciated about 1% (see Figures 1 and 2). The overall driver is the perceived view that the risk-reward of investing in EM (versus developed) markets has improved, both due to better relative returns and more limited risks.

Olivier Desbarres Sweet and Sour Fig1

Low (or negative) developed market yields highlight attractiveness of high-carry currencies

Major developed central banks’ willingness to keep monetary policy loose in order to put a floor under economic growth is central to this improved risk-reward trade-off for EM assets. The US Federal Reserve has kept its policy rate on hold at a near-record low since December and is unlikely to hike rates until its 21st September policy meeting at the earliest, despite decent US labour and household spending data. The Bank of England, European Central Bank and Bank of Japan have all hinted at a possible further loosening of monetary policies.

Near-zero or sub-zero government bond yields in most developed markets have certainly helped put in high-relief high-carry currencies, notably those of economies which are also benefiting from high global metals prices. The Brazil Real and South African Rand have indeed outperformed their EM peers (see Figure 2).

Olivier Desbarres Sweet and Sour Fig2

Global growth and commodity prices have so far done enough to support EM assets

On the risk side of the equation, slowing rather than collapsing global growth and higher commodity prices have for now attenuated concerns about EM economies’ ability to prosper. Moreover, stable and still significant central bank FX reserves have dulled fears about EM central banks’ ability to defend their currencies in the event of a more acute and/or prolonged shock, whether domestic or exogenous.

Global GDP growth

Based on data for the US, European Union (EU), China, Korea and Singapore – which account for about half of world GDP – global GDP growth slowed marginally in Q2 to around 2.7% yoy following 2.8% yoy growth in both Q1 2016 and Q4 2015, according to my estimates. This would be broadly consistent with the global manufacturing PMI which fell only slightly to 50.2 in Q2 from 50.5 in Q1 (see Figure 3).

Going forward, the UK economy remains prey to post-referendum uncertainty but only accounts for 4% of world GDP. More positively, Prime Minister May’s new government and its EU counterparts have shown a willingness to move forward, even if slowly, in their negotiations over the UK and EU’s future relationship.

Global commodity prices

The price of crude oil is down about 17% since its early June peak, which at the margin has weighed on the currencies of oil exporting nations such as Mexico and Russia (see Figure 2). Conversely, the price of natural gas has been reasonably steady and the price of metals (including gold, platinum, copper, zinc, nickel and iron ore) has risen to multi-month highs. This has been particularly beneficial to Brazil – one of the world’s largest exporters of iron ore and nickel – and South Africa, amongst the world’s largest exporters of platinum and gold – and their respective currencies.

EM central bank FX reserves

The pick-up in commodity prices alongside larger capital inflows into EM economies have helped keep EM central bank FX reserves broadly steady since February at around $7.65trn (see Figure 4)[1]. FX reserves remain near record highs, particularly when currency-valuation effects (US dollar strength) are taken into account (see FX reserves – all things considered equal, 14 April 2016).

In aggregate EM FX reserves are still very large, but the picture is differentiated at a country level. Reserves are considerable in NJA economies, bar Malaysia, India and particularly Indonesia, but are small in most of Latin America and in major African economies (including Egypt, Nigeria and South Africa). This is likely to continue influencing the ability and willingness of these countries’ central banks to slow, let alone stop, currency depreciation by intervening in the FX market.

Olivier Desbarres Sweet and Sour Fig3and4

Perceived distinction between developed and EM risks becoming blurred

At the same time, the emergence of acute economic, political and geo-political risks in developed economies has led markets to revisit the perceived notion that emerging countries’ economies and political set-ups are inherently less stable and more risky.

Brexit, tragic terrorist attacks in France and Germany, the rise of pan-European nationalism, the weakness of Italian banks and uncertain outcome of the forthcoming US presidential elections have for now at least partly over-shadowed the challenges facing emerging markets. These include corruption scandals in Brazil, Malaysia and South Africa, China’s territorial disputes in the South China Sea, India’s unfinished reform drive, the collapse in the Nigerian Naira and the Philippines government’s brutal war on drugs. The contagion to emerging markets from the aborted coup in Turkey on 15th July was negligible and quickly reversed.

Put differently, developed market economies in aggregate remain just about strong enough to drive EM growth but are sufficiently weak and susceptible to endogenous shocks to highlight the attractiveness of EM assets. The question is what, if anything, is likely to destabilise this fine balance.

 

US and China likely to remain epicentres of any future EM sell-off

Perhaps unsurprisingly, the two events which have seriously rattled EM assets, including currencies, in the past year had their epicentres in the world’s two largest economies (see Figure 1):

  1. The decision by the People’s Bank of China (PBoC) to “devalue” the renminbi by 2% versus the dollar on 11th August and subsequent government tinkering with Chinese equity markets; and
  1. The Fed’s first hike in a decade on 16th December – or more precisely the market’s fear of further Fed hikes in quick succession.

While unknown-unknowns have the potential to strike anywhere and anytime and destabilise emerging markets, an EM crisis is still more likely to have its birthplace in the US or China than Europe for example, in my view. The health of the US and Chinese economies and soundness of their government policies remain the most important drivers of EM equities, bonds and currencies.

 

US – Risk of history repeating itself…with added complication of US presidential elections

US GDP growth remains too weak to single-handedly lift global growth from its multi-year lows, with the US manufacturing sector weighed down by a strong dollar. The latter, along with the UK referendum outcome, have dulled any sense of urgency with regards the timing of the Fed’s next rate hike.

The Fed has also seemingly learnt its lesson from early 2016, when it failed to quell market concerns that a rapid tightening of US monetary policy could derail global sentiment. It has in recent months repeated its mantra that any future rate hikes would be modest and gradual. Even prior the UK referendum on 23rd June, the Fed’s latest dot chart (dated 15th June) revealed that the 17 FOMC members’ downwardly revised weighted average forecast was for only 45bp of hikes in the remainder of 2016.

If US GDP growth picks up in Q3 from a lacklustre 1.4% yoy in H1 2016 (see Figure 5) and the labour market remains reasonably tight, the Fed may have to start thinking more seriously about preparing a market which is currently only pricing in 12bp of hikes (or half a full 25bp hike) by end-year. If the Fed turns hawkish too soon, markets may (again) be spooked by the prospect of tepid US growth and tighter US monetary policy. If the Fed leaves it too late, markets could struggle to digest the implications of a second hike in a decade. Timing and language, as often the case, will be key.

If US growth fails to accelerate meaningfully in Q3, the US Fed funds rate may well remain unchanged until 2017 but EM will have to contend with a weak major trading partner, leaving Latam and Non-Japan Asian economies particularly vulnerable.

Olivier Desbarres Sweet and Sour Fig5and6

The US presidential elections scheduled for 8th November are a further complication and present a significant event-risk to emerging markets and their currencies (see Figure 10). Donald Trump, the Republican candidate, has so far been short on policy-specifics. But his proclivity for protectionist policies could, all other things equal, be damaging to countries for which the United States’ is a main trading partner, including Mexico, Brazil, China and the majority of Asian economies.

 

Markets likely to remain sensitive to any Chinese policy “mistake”

China’s economy remains dependent on loose credit policy to finance (often unprofitable) government and private sector investment (see Figure 6), leaving it vulnerable to banks’ growing non-performing loans. This issue is far from resolved but the government has at least started to address a problem long in the making. Moreover, it has curbed its damaging manipulations of domestic equity markets.

Finally, the PBoC has stayed well clear of blatant one-off devaluations of its currency, instead opting for a slow or at least more gradual weakening of the Renminbi NEER (see Figure 7). The pace of monthly depreciation in the CNY NEER accelerated beyond its historical trend in early July (to around 3%) but has since returned to norm (see Figure 8).

However, history shows that markets are likely to remain extremely sensitive to any policy mistakes, whether real or perceived. After all it only took a 2% CNY devaluation a year ago – which in most contexts would be regarded as a pretty benign move – to trigger months of pain for EM currencies and equities.

Olivier Desbarres Sweet and Sour Fig7

EM asset prices so far resilient to European turmoil

The relative resilience of EM asset prices in the past 18 months to made-in-Europe stresses can be partly attributed to the eurozone’s slow economic recovery and reassuringly stable euro (see Figure 9). ECB President Draghi’s calm and collected approach could arguably take some credit for the latter.

EM currencies were broadly unchanged during the Greek crisis which dominated headlines for the first eight months of 2015 (see Figure 1). The argument at the time was that Greece’s economy was very small in the global context and that European leaders would ultimately fudge a solution which would keep Greece in the eurozone and EU, if not solvent – an expectation which was met.

Italy’s economy is far more significant – the third largest in the eurozone and nearly ten times the size of Greece’s. But again markets seem confident that EU leaders and the Italian government will find a compromise solution to keep Italian banks afloat and minimise the impact on bond holders and taxpayers – an expectation which I share.Olivier Desbarres Sweet and Sour Fig8and9

Olivier Desbarres Sweet and Sour Fig10

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


[1] Includes Albania, Armenia, Belarus, Bulgaria, Croatia, Egypt, Georgia, Hungary, Jordan, Kazakhstan, the Kyrgyz Republic, Lithuania, Moldova, Morocco, Nigeria, Poland, Romania, Russia, Saudi Arabia, South Africa, Tunisia, Turkey and Ukraine, Argentina, Brazil, Chile, Colombia, El Salvador, Mexico, Peru and Uruguay, Hong Kong, India, Indonesia, Korea, Malaysia, Philippines, Singapore, Thailand and Taiwan

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