South_Korea

SOUTH KOREA: GOOD FUNDAMENTALS CONTINUE TO SUPPORT THE WON

The Korean economy has improved as Q2 GDP rose 3.3% y/y, the highest growth in 2 years. Domestic demand continues to grow modestly, owing to the government fiscal stimulus. Inflation pressures in Korea remain weak. In August, headline CPI inflation slowed to 0.4% y/y, below the 2.5-3.5% target range. Core inflation was 1.1% y/y, the lowest since December 2012. The Bank of Korea (BOK) cut rates by 25bp to 1.25% in June and has kept rates until September. BOK is likely to cut more in Q4 under weak inflation pressures and steady won.

The external accounts have been solid. Lower oil prices have helped reduce imports, and offset the downward pressure on exports. The current account surplus is expected at around 8.2% of GDP in 2016, which continues to improve from 7.7% in 2015. Favorable South Korean fundamentals should support the won. S&P recently upgraded Korea one notch to AA with a stable outlook, citing its sound fiscal position and flexible fiscal and monetary policies.

South_Africa

SOUTH AFRICA: DOWNGRADE RISK SHOULD WEIGH ON THE RAND

South Africa faces a period of political and economic uncertainty. Its Finance Minister Gordhan was called to appear by the police, concerning allegations of a connection to a spy unit during his time as head of South Africa’s tax authority. The arrest is said to have been led by President Zuma, who has clashed with Gordhan over policy.

In recent local elections, South Africa’s ruling party ANC suffered its worst electoral setback since apartheid ended in 1994. The ANC has lost public support due to weak economic performance and political scandals. The ANC under Zuma could expand fiscal expenditure in an effort to recover support, which would worsen fiscal condition and raise the risk that South Africa would be downgraded to sub-investment grade.

The South African economy remains weak. Q2 GDP rose 0.6% y/y, following -0.1% y/y in Q1. The South Africa Reserve Bank (SARB) cut its growth outlook to 0.0% from 0.6% in 2016. Weak growth should enhance downside risk of government revenue and make it more difficult to cut expenditures.

Inflation remains high at the upper end of the 3-6% target range. The SARB has hiked rates to 7.0%, the highest since January 2010. Inflation could move above the upper end of the target range, but the SARB will likely keep rates steady due to the weak economy. The rand remains vulnerable to possible risk off sentiment, changes in US monetary policy, and concerns over rating downgrades, while it has been supported by high yields.

Turkey

TURKEY: STAGFLATION LIKELY TO CONTINUE UNDER ERDOGAN’S CRACKDOWN, LIRA TO REMAIN FRAGILE

The economy remains sluggish as Q2 GDP growth slowed to 3.1% y/y, the lowest since Q1 2015. The external accounts are in decent shape but are not expected to improve much more. Russian sanctions and the slowing China economy have worsened exports and tourism.

Inflation pressures remain high as core CPI remains above 8% y/y and headline CPI remains above the 3-7% target range. Increase in minimum wage and rebounding oil price should keep inflation expectation high.

The central bank should hike rates amid high inflation. However, it has kept policy rates at 7.5% and continues to cut its overnight lending rate (the sixth straight reduction). Turkey’s President Erdogan continues to crackdown on anti-government groups after the failure of the July coup attempt. The Turkish government may be eyeing the central bank for the next purge. Prosecutors are now saying the bank is dominated by Gulenists, citing as evidence the image of Halley’s Comet on Turkish banknotes.

The lira remains fragile due to hot money flows. Turkey’s short-term external debt continues to decrease to $107.5 bln at the end of June, but it is 105.7% of its foreign reserves. Usable reserves, which net out commercial bank foreign currency deposits at the central bank, have fallen to a meager $30 billion. Inflows will be hurt further by Moody’s decision to downgrade Turkey to Ba1, which followed S&P’s downgrade this summer to BB. Since many investment mandates require at least two investment grade ratings in order to be investable, Turkey should see some forced selling.

Mexico

MEXICO: LOWER OIL PRICE CONTINUES TO WEIGH ON THE PESO

The Mexican economy remains weak as Q2 GDP contracted 0.2% q/q, the first negative growth for 3 years. Weak manufacturing has depressed growth, even as the service sector has also softened. Tightened fiscal and monetary policies continue to weigh on the economy while overseas worker remittances remain firm thanks to a steady US economy.

Inflation pressures are picking up due to low base effects and weak peso. Headline CPI accelerated to 2.73% y/y in August and core CPI has been at around 3% y/y since June. The Banco de Mexico sees inflation staying at around 3% until the end of 2016.

The weak peso is likely to boost price pressures in Q4. The peso remains fragile due to lower oil prices and the risk of the US hiking rates. The peso still has strong correlation with oil prices and has been considered a proxy for EM. We downplay notions that peso weakness is stemming from rising odds that Donald Trump will win the election. Foreign reserves have stabilized at around $176 billion.

The Banco de Mexico hiked rates by 50bp to 4.25% in June and has left rates unchanged since. It said the 50 bp hike would help curb inflation risks. Governor Carstens has mentioned exports have been much weaker than expected given the depreciation of the exchange rate.

The government maintains fiscal austerity. Ex-Finance Minister Videgaray, who resigned due to inviting Trump, said the nation needs to restore fiscal balance. Incoming Mexican Finance Minister Meade announced new spending cuts. The 2017 budget proposes spending cuts of MXN239.7 bln (MXN169.4 bln already announced plus MXN70.3 bln newly announced) to help reach a primary surplus equal to 0.4% of GDP. This would be the first primary surplus in 8 years. The budget assumes growth of 2-3% next year, down from 2.6-3.6% forecast back in April.

Brazil

BRAZIL: ECONOMY BOTTOMING, POLITICS STILL MURKY

Brazilian political uncertainty has cleared up a bit, and yet some cloudiness remains. Dilma Rousseff was impeached by a wide margin, and yet the populace remains highly polarized. Protests have already sprung up against new President Temer, and there are signs that planned austerity measures will be harder than ever to push through. Meanwhile, corruption investigations continue to spread. Brazil’s four biggest pension funds recently have been targeted in a probe, with all four tied to state-run companies. The recent expulsion of lower house chief Cunha has raised fears that he will implicate others, including members of the Temer administration.

The economic outlook remains weak. Inflation remains stubbornly high, and there are growing risks that the first rate cut may not be seen at the next COPOM meeting October 19. Tight monetary and fiscal policies will certainly add to the growth headwinds. The economy is bottoming, however, and a modest cyclical recovery is likely next year. This should help prevent further downgrades to Brazil’s sovereign ratings.

The central bank has cut the size of its daily reverse swap auctions. This is a signal that it is less concerned about currency strength, which is not surprising in light of the recent EM sell-off. Still, we hope that the authorities do not try to micromanage the exchange rate. During a time of heightened market volatility, such actions could add fuel to the fire.

China

CHINA: MAINLAND DEVELOPMENTS NO LONGER MARKET-MOVING (FOR NOW)

China continues to slow, albeit at a pace that so far has not roiled markets. Indeed, the best that can be said for China is that it has lost its propensity to shock the markets, at least for now. It appears that the PBOC is reluctant to ease monetary policy any further due to worries about financial stability. As such, markets should be prepared for further slowing in the economy.

We do not expect a one-off devaluation in the foreseeable future. USD/CNY has remained very stable, trading in the 6.60-6.70 range for most of H2. With market forces given a greater role in determining the exchange rate, we think much will depend on how the dollar trades in the coming months.

Meanwhile, the authorities continue to open up China’s financial markets. The latest development is the establishment of the Shenzen-Hong Kong exchange link. This follows the Shanghai-Hong Kong link, and allows foreign investors greater access to the local stock markets. These sorts of measures should continue to be seen, albeit at a cautious pace.