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.