Emerging Markets Under Pressure: Global Backdrop Remains Challenging

EM is likely to remain under pressure. The only EM currencies up year to date are BRL, PEN, and MXN. We don’t count RUB because the exchange rate is meaningless until foreign investors are allowed to sell their holdings and repatriate the proceeds. COP, ZAR, and CLP have all seen their earlier YTD gains erased. For much of the first half of this year, high interest rates and rising commodity prices helped these currencies outperform their EM peers. However, broad-based dollar strength has slowly but surely eaten away at those EM FX gains and this is likely to continue as the Fed remains on its aggressive tightening path.

Global liquidity is tightening at an unprecedented pace. The ECB recently joined the ranks of the Development Market central banks that are tightening monetary policy. That leaves the Bank of Japan as the only DM central bank to remain on hold. Meanwhile, EM central banks have also been hiking rates aggressively.

Weaker credits will likely struggle to finance twin deficits. As it is, Frontier Markets such as Sri Lanka and Pakistan are already in crisis. Kenya and Nigeria are experiencing some dollar shortages, making it difficult for some foreign investors to repatriate their earnings. This is only going to get worse. That said, we are not calling for any sort of contagion effect. Rather, every country is facing the same problems as every other country. Those countries with strong fundamentals will weather the storm, while those with weak fundamentals will suffer the most.

Global recessions risks are rising. China poses a big risk to global growth. As we will go into detail in this section, the world’s second largest economy is slowing much more than markets anticipated. Emerging Asia will be most vulnerable due to trade and investment ties with the mainland. In Europe, it appears that Germany and Italy are already tipping into recession, and it’s only a matter of time before the rest of the eurozone follows. The U.K. is likely to enter recession in Q4. Here, Central and Eastern Europe is most vulnerable as the bulk of their exports go to Western Europe. The U.S. economy remains relatively strong but cannot fully offset slowdown in eurozone and China.

People’s Bank of China Pivots. Or does it?

The central bank has been sending mixed messages. It recently said that it would safeguard the economy against high inflation and pledged not to rely on excessive monetary stimulus to boost growth. In its quarterly monetary policy report, the PBOC noted that “Structural inflation pressure may increase in the short term, and the pressure of imported inflation remains. We can’t lower our guards easily.” The bank added that inflation will likely exceed the 3% target in some months in H2 but said it will likely achieve the target for the full year due to measures taken to ensure grain and energy supplies as well as its prudent monetary policy. Yet days later, the bank unexpectedly cut its key 1-year MLF 10 bp to 2.75% after a run of weaker than expected data.
 

Further PBOC easing now seems likely. With the economy growing only 0.4% y/y in Q2 and the full year growth target of “around 5.5%” clearly in danger, we expect further stimulus in H2.  This means that monetary policy divergence with the Fed will still continue, albeit all from the U.S. side. Spreads are moving further in the dollar’s favor; this should weaken the yuan further and weigh on fixed income returns.

The Year of Living Dangerously

President Xi Jinping faces many challenges as he gears up to win an unprecedented third term at the 20th National Congress of the Chinese Communist Party this November. It’s clear that the economic slowdown will be deeper and more prolonged than expected as policymakers stick with the COVID Zero policy. Social unrest may creep higher as recent protests by depositors demanding frozen funds from rural banks are quashed; property sector remains troubled. Crackdown on tech sector and tensions with the U.S. over Taiwan are likely to keep inbound foreign investment subdued.

Asia Will Suffer From China’s Slowdown

Most Asian central banks have started tightening cycles. However, the pervasiveness of administered prices in this region has limited inflation and allowed these central banks to hike quite gradually compared to the other EM regions. At 5.4%, India’s policy rate is the highest in the region. Thailand just started its tightening cycle, leaving Indonesia as the last to hike. Korea stands out for its aggressive tightening cycle. The swaps market sees the BOK policy rate peaking at 3% over the next 12 months. 

Two other central banks deserve a mention. Singapore has tightened four times this past year by adjusting its S$NEER.  With inflation still climbing, the Monetary Authority of Singapore is likely to tighten again at its October policy meeting. Elsewhere, Hong Kong has been forced to tighten because of the HKD peg. We believe the HKMA will successfully defend the peg but at a cost to growth. 

CEE Remains Very Vulnerable

The region’s central banks are starting to pivot. This is due in large part to the fact that CEE is most vulnerable to negative impulses from the Ukraine crisis and eurozone recession, as most of the region’s exports go to Western Europe. All are net energy importers too, putting further stresses on their economies. The recent decision by Czech Republic to end tightening cycle is risky when inflation is running at 17.5% and rising. Poland too is signaling that it is nearing an end to its tightening cycle despite inflation running above 15%. Surprisingly, Hungary has been the most aggressive in hiking rates and so far shows no hint of stopping anytime soon. Indeed, the swaps market is pricing in another 125 bp of tightening over the next 6 months that would see the policy rate peak near 12%. Contrast this to Hungary and Poland, where markets have priced in the end of their tightening cycles. 

Turkey gave markets a big reminder of why it remains un-investable. With inflation running near 80% (and rising), the central bank unexpectedly cut interest rates 100 bp to 13%.  And so President Recep Tayyip Erdoğan long-standing experiment with unorthodox policies continues.  The exchange rate remains heavily managed. Otherwise, we suspect it would be well north of 20 by now given the poor fundamental outlook. In particular, the twin deficits have been widening significantly and they cannot be financed domestically. Foreign investment is desperately needed and yet interest rates are not being allowed to rise to levels that would draw in foreign inflows. We believe Turkey is moving steadily towards a balance of payments crisis that could quickly turn into a severe economic downturn. 

Latin America Lurches Left

Lower commodity prices and higher interest rates are likely to weigh on regional growth.  With China slowing sharply, regional exports of copper and iron ore are likely to slow. Mexico, with its greater ties to the U.S., is likely to outperform in the region in terms of economic growth. Brazil has been the most aggressive in terms of monetary tightening but the economy is starting to pick up as fiscal stimulus hits ahead of the October elections.

Political risk is high as the region lurches left. President Gustavo Petro just took power in Colombia this month, President Gabriel Boric took power in Chile this March, and President Pedro Castillo took power in Peru last July. They join President Nicolas Maduro in Venezuela, President Andres Manuel Lopez Obrador in Mexico, President Alberto Fernandez in Argentina, and President Luis Arce in Bolivia. If Lula wins in Brazil this fall, virtually every major economy in the region will be leftist. Investors will be watching for signs of tangible policy shifts, as many past leftist governments in the region have eventually been pulled to the center.   

In that regard, Chile may provide a reassuring signal. It seems that the new Chilean Constitution that was written by the left-leaning Constitutional Assembly does not yet have enough popular support to pass the September 4 referendum. The new constitution came about after the widespread demonstrations in 2019 and 2020 protesting income inequality.  However, reports suggest that the government and its allies may propose changes to some of the more controversial areas in order to get more support in next month’s vote. Supporters believe the proposed constitution will strengthen social rights and protect the environment, while detractors believe it will deter investment and hurt growth.

In Brazil, most polls show former President Lula beating current President Bolsonaro in the run-off. Indeed, some even show that Lula has a chance at winning in the first round. Even after Bolsonaro’s big pre-election spending spree, the incumbent continues to trail Lula in all polls. The first round will be held on October 2 and if no candidate wins a majority, the top two vote-getters will go to the second round runoff on October 30. Lula is a known quantity and so his likely victory has not had the negative market reactions that we saw in the run-up to his first victory back in 2002. Lula has already signaled that he will remain on the orthodox path with the choice of Geraldo Alckmin of the Brazilian Social Democratic Party (PSDB) as his running mate.