EM Turbulence To Continue As Policymaking Becomes Increasingly Difficult
The current turmoil in emerging markets (EM) is a result of external and internal risks that we have been flagging up for some time now. These include a slowdown in China as well as the normalisation of monetary policy in the US. Moreover, many EMs have also seen a deterioration in their macroeconomic and political risk profiles as a slowdown in growth has exacerbated social tensions. The recent moves in global equity markets dovetail with our core asset class strategy of US equity outperformance versus the MSCI EM equity index, which has been in place since October 2010. While the view had originally been underpinned by our relatively bullish view on the US, the development of macroeconomic imbalances in EM is further bolstering the relative value play. The question now is whether this correction in EM assets is short-term in nature or the start of a more prolonged period of investor risk aversion.
|Developed Market Equities To Continue Outperforming|
|Ratio of MSCI Developed Markets Equity Index To MSCI EM Equity Index|
Over a long- term horizon, we remain bullish with regard to the EM growth and consumer stories, as most countries have made significant headway with regard to economic, institutional and political reform over the past decade. However, the slowdown in growth in emerging markets will make the economic and political environment increasingly challenging over the coming years, for both policymakers and foreign investors. This will result in much tougher policy trade-offs and could lead to short bouts of economic and political risk for different countries. As such, while EM selectivity will remain key, this merely reinforces both our bullish stance towards US equities over EM equities, and our view for medium-term US dollar strength. We note that:
• A slowdown in China will hit commodity producers particularly hard, and this could weigh on the fiscal profile of many emerging markets.
• The normalisation of monetary policy in the developed world will cause a major headache for central banks as they will be forced to choose between stimulating growth and reining in inflation.
• The easier reforms have been made already, and this, combined with weaker economic fundamentals, the election cycle, and little scope for reform means that policymaking will become increasing ly d ifficult and potentially polarising .
• Countries with a good track record of policy continuity, stable and entrenched democratic institutions , and a strong, independent central bank , will most likely fare better.
|Slowing Growth Will Exacerbate Social Tensions|
|Real GDP Growth By Region (% Chg)|
The deterioration in the economic environment for emerging markets will come from both international and domestic factors, and how individual governments and central banks address these challenges will determine the outlook for their particular countries. On the one hand, politicians that choose to offset the slowdown in growth by expanding fiscal policy could see a sustained deterioration in their country's fiscal profile. On the other hand, governments that try to tighten fiscal policy may face a political backlash, which could cause a surge in political risk, as has been the case in Indonesia recently. Central banks will also face a very hard set of policy decisions as they juggle the trade-off between the potential for rising inflationary pressures and slowing growth in the midst of rising global bond yields. How central banks deal with these challenges will have a significant impact on policy credibility going forward, with countries such as Japan, Brazil and China raising question marks over current monetary policy. The key test will be how governments and central banks coordinate policy in order to achieve their common objectives.
|Exposure To China Is A Curse In Disguise|
|Exports To China, Percent of Total|
External Environment To Cause Growth, Interest Rate And Inflation Headwinds
We see two main headwinds arising from the external sector: slowing demand and the normalisation of monetary policy in the developed world. In terms of demand, we forecast Chinese growth to slow to 7.7% in 2013 and then 6.7% in 2014, and this will have a significant impact on commodity producers such as Chile, Peru, Zambia and Mongolia, to name but a few. Indeed, exports will suffer on the back of falling prices and weaker demand, which may increase the vulnerability of these countries' external sector. Moreover, foreign direct investment and loans-for-commodities type arrangements could also become scarcer, which would also impact longer-term productivity and growth. Furthermore, we forecast an anemic recovery in the eurozone over the coming years, which means that many emerging economies that had previously relied on European demand will only see slow demand growth. Importantly, the slowdown in growth could also have a huge impac t on a government s ' fiscal profile, particularly if policymakers look to expand fiscal policy in order to offset slower growth at a time when revenues will also be taking a hit.
|Sovereign Risk Is Being Re-priced|
|5 Year Sovereign Credit Default Spreads (bps)|
In terms of the normalization of monetary policy in the developed world, rising bond yields in the US (and interest rate hikes in the coming years) will result in the re-pricing of risk in emerging markets, which will cause bond yields to rise over the coming quarters and potentially further weaken EM currencies. This means that the cost at which governments fund themselves will likely rise, causing additional pressure on their fiscal accounts. In terms of monetary policy, central banks will be faced with a difficult combination of slowing growth, rising bond yields and imported inflationary pressures (on the back of currency weakness). In order to maintain policy credibility, central banks will have to focus on tackling the threat of inflation, which could have a detrimental effect on growth and could cause friction with politicians, potentially even bringing into question their independence.
|Fiscal Slippage To Weigh On Policy Responses|
|Fiscal Deficit (% of GDP) For Select Countries|
Domestic Headwinds Will Also Prove A Significant Challenge
We also see huge challenges ahead for policymakers due to domestic factors which include: weaker economic fundamentals, political risk associated with election cycles, and significant headwinds to reform . In terms of economic fundamentals , most EMs came out of the global financial crisis with much weaker fiscal and balance of payments positions than when they entered it and we have seen little in terms of policy to suggest that they will improve substantially. Indeed, we forecast a majority of countries will continue to post fiscal deficits over the coming years and this will likely lead to an increase in overall debt. This means that politicians will be faced with two choices: either consolidate fiscal expenditure at the risk of rising social tensions, or continue to ramp up spending to the detriment of the country's fiscal profile. The choice will largely be dictated by the political cycle, as we explore in the next section.
|External Vulnerabilities Will Rise|
|Current Account Deficit (% of GDP) For Select Countries|
In terms of balance of payments positions, the combination of growing domestic demand, a weaker external sector and declining investment into productive assets suggests that many EMs will continue to post current account deficits, or see their surpluses deteriorate - with Russia being a case in point, as we forecast it will slip into a current account deficit by 2017. Moreover, there has been a general downtrend in levels of import cover, which means that many current account deficit countries will remain vulnerable to funding gaps.
|External Buffers Have Weakened Too|
|Months of Import Cover|
This is particularly important given that foreigners hold an increasingly large portion of EM assets, even despite the recent outflows. As such, a move towards larger fiscal and current account deficits would certainly put foreign investors on the back foot, and would leave central banks on the hook to defend their currencies at the expense of growth during periods of significant risk aversion.
|Source: Respective Central Banks, MacroBond, *Q412|
We expect the election cycle to pose headwinds to policymakers in emerging markets. Over the next eighteen months Presidential and/or legislative and gubernatorial elections will take place in major countries such as India, Indonesia, Brazil, Mexico, Argentina, Chile and South Africa. Should slower economic growth result in rising social tensions, policy platforms could become i ncreasingly populist and polaris ed. Such a dynamic could have a significant impact on a country's fiscal accounts, while potentially hurting the country's attractiveness as an investment destination as politicians backtrack on previously unpopular agreements. Indeed, we have already seen significant political backlash in countries such as Indonesia, where the government tried to increase fuel prices, and in Brazil, where an increase in bus fares sparked a series of protests in major cities. As such, politicians going into an election cycle may opt to delay fiscal tightening in the short run in order to win voter support. Moreover, in countries like Turkey, the slowdown in growth, combined with a more authoritarian stance by the government, sparked huge demonstrations, which are weighing on the country's political and economic outlook.
|Capex To Fall Further|
|Global Mining Capital Expenditure (US$mn) & S&P GSCI Industrial Metals Index|
Furthermore, we have also seen an uptick in political risk in the mining sector in several countries such as Peru (indigenous movements), South Africa (protests over wage and working conditions) and Mongolia (renegotiation of existing contracts) to name but a few, which, combined with falling profitability, has resulted in several major miners scaling down investment plans. Combined, these risks could have a significant negative impact on the economic outlook for these countries as investors lose confidence and pull capital out. This would pose a headache for central banks as they would be faced with significant depreciatory pressures on their exchange rates, which would pose inflationary pressures at a time when growth could slow.
|Inflationary Pressures Could Tick Higher|
|BMI Global Inflation & Interest Rate Index|
Reform will be difficult as the easier policies have already been implemented and further improvements will be increasingly harder to come by . For example, inflation has come down significantly in recent years, and with it, so have interest rates. While inflation targeting, central bank independence and prudent macroeconomic management played a key part in this, many EMs also benefited from rapidly appreciating exchange rates (which pushed down import costs) as well as the disinflationary pulse during the global financial crisis. While we doubt inflation will be a massive problem going forward, the increase in liquidity by central banks around the world, combined with key structural supply constraints and the potential for weaker exchange rates across the EM universe, mean that inflation could start to rise over the coming years, which will pose dilemmas for policymakers, and in particular central banks.
|Hard To See This Moving Much Lower Without Reform|
|Unemployment (%) For Selected Countries|
Moreover, trends in employment point to a similar picture. Unemployment fell substantially as a period of strong economic growth pulled in workers from the informal sector and helped reduce the overall level of unemployment. However, given the potential for increased populist rhetoric and political polarisation, we see huge headwinds to substantial reform over the coming years, which in our opinion would be needed to achieve lower levels of une mployment and inflation as well as address other structural issues that many of these economies face. Failure to see improvements in these key metrics could result in outburst s of political risk, which would be difficult for policymakers to address. Given these dynamics, we expect policymaking in several countries will become increasingly difficult and unpredictable.
|S-T Political||L-T Political||S-T Economy||L-T Economy||Business Environment||Composite|