We expect an initial period of broad gains and carry-focused trade strategies at the start of the year in which high-beta plays will outperform. A few Latin American currencies are well-positioned to capture these initial gains, recovering some lost ground during the protests that swept through the region. Eventually, however, markets should settle into differentiation mode, when fundamental weaknesses and idiosyncratic factors will become a drag on performance of the weaker countries such as South Africa, Turkey, and India.
Our call for a gentle uptrend in US yields and the dollar (vs. domestic markets) should not represent a threat to EM because it’s happening for the “right reasons” (i.e. relatively better global growth outlook). Politics will remain a major source of downside risk, but we expect less of it from US President Donald Trump. The proximity to the elections means he will occupy a stabilizing role to avoid rocking the boat, even if that means fending off Congressional initiatives such as the recent ones against Turkey and China. Trump could, however, decide to pick other countries as targets to keep up his hawkish credentials. Either way, sensitivity to political events will remain high, as it was in 2019. Countries that experienced social unrest in 2019 will remain “on watch” and might command a protest risk premium for some time.
After underperforming for most of the year, major Latin American currencies have turned a corner in December, and we think they can outperform in early 2020. Investors will remain sensitive to political developments, as the impact of the protests on the regional’s fiscal outlook and prospects for reforms remains to be seen. But this doesn’t look like a major risk going forward. Moreover, FX intervention in Chile and Brazil will help to take the sting off new bouts of currency weakness, and many idiosyncratic factors weighing on the region have already played out.
Concerns about social unrest in Chile and Colombia have abated, and the Chilean peso in particular has a lot of room to recover. In Colombia, we are worried about fiscal slippage in reaction to the protests which could trigger a ratings downgrade. Mexico’s central bank will continue easing, but rates should remain high relatively to other EM currencies into 2020. External conditions permitting, we think markets should look past Mexico’s weak economic outlook and focus on the currency’s ample carry opportunity while it lasts. In Brazil, we expect a greater interest by foreign investors in the country’s equity markets after substantial outflows in 2019 amidst some signs of economic improvement. While carry will no longer be a source of support for the real, outflows from companies switching from dollar-denominated to local currency debt should diminish and the political landscape seems stable for now. Argentina will remain a wildcard. The ministerial cabinet under the new Fernandez government is shaping up as expected (leaning towards the heterodox ideological camp). The country has a tough year ahead between renegotiating debt payments amidst a very challenging economic backdrop.
We don’t see a lot to get excited about when looking at the major countries in the EMEA region. For South Africa, we believe that investors are aware and have priced in the myriad of risk factors for next year: the Moody’s downgrade, a dire economic backdrop, and energy blackouts. We prefer to stay on the sidelines regarding the rand given better investment prospects elsewhere. Similarly, we prefer not to get involved in Turkey, but for different reasons. We still think Trump has moved into a buffer role and will strive to protect Turkey against US Congressional hostility. The problem is that he may not be able to do much given the remarkable bipartisan agreements in matters of foreign policy. Trump still has some cards to play such as waivers and selecting innocuous Countering America’s Adversaries Through Sanctions ACT (CAATSA) sanctions, but the setup allows for a lot of downside risk potential. Eastern Europe has some upside risk from trade with the EU, which depends on a rebound of the industrial (and specifically automobile) sector in German. There have been some green shoots in Q4, but no definitive signs that they are blossoming into a robust recovery.
US-China trade war and new tech cycle emerge as foremost themes. We see two emerging themes for the region in 2020: (1) changes in the distribution of gainers and losers in the next phase of the US-China trade war, and (2) the tech cycle. Our short answer to the first is that there will probably not be a huge change. Some beneficiaries of export dislocation, such as Vietnam and Taiwan, are at risk of losing the gains accrued last year. On the positive side, the prospect of a rebound in trade between the US and China could trickle down the Greater China supply chain. But this is not our base case. We don’t expect the region to get a meaningful boost from an agreement between the US and China – at best it could translate into less of a drag and an improvement in sentiment towards assets in the more sensitive countries such as South Korea. Regarding the impact of the broader tech cycle on the region, it’s entirely up to who will be the democratic nominee. We would expect local equity markets to take a big hit should Elizabeth Warren emerge as the victor.
The longer-term damage to China’s trade has been done. The rise in anti-China sentiment across both parties in the US suggest that the conflict is here to stay, regardless of who is in the White House for the next term. Not even the most optimistic trade agreement between the US and China we can envision will change that. International businesses are now forced to consider a permanent level of uncertainty about future disputes between the US and China, forcing many to re-think how they want to involve China in their production chains and FDI going forward.
Economic activity in China should remain subdued despite monetary and fiscal country-cyclical policies. Most expect GDP growth to come in somewhere around the 6.0% level, but there seems to be more downside than upside risks at this point. From a growth point of view, India is set to be a bright spot in the region. The economy should get a boost from many fronts including the impact of lower interest rates and tax cuts for the corporate and consumer sectors, capital injections into the banking sector, income support, and good rainfall for farmers. But the risks are shifting to the local bond market as the curve steepens with expected fiscal slippage and the possibility of a rating downgrade. The outlook for South Korea will depend heavily on the balance between the downside risks from trade (US-China, as well as the dispute with Japan) against the impact of an expansionary fiscal policy next year.
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