Emerging Markets have been buffeted by a variety of negative factors this year, but have remained resilient. The overriding factor is that the global liquidity backdrop remains supportive of “risk.” We expect this favorable outlook to continue (more or less) into year-end. It appears, however, that the markets are at an inflection point, which may be enough to put some downward pressure on risk assets near-term.

Let’s review the global outlook. The US economy hit a soft patch in H1. While it appears to be strengthening in Q3, this softness has helped push out Fed tightening expectations significantly. The September 21 meeting was clearly too soon to hike again, while the November 2 meeting will be avoided due to the proximity of the US elections. That leaves the December 14 FOMC meeting. Until then, we foresee a window, a sweet spot if you will, where EM can regain some traction.

Yet the backdrop has subtly shifted, making markets nervous. Recent policy meetings suggest that further easing by the BOE, BOJ, and ECB may not be forthcoming. This is the inflection point that we mentioned, and it seems to be having an impact similar to that of the “Taper Tantrum” of 2013. Then, as now, markets are being roiled by the potential for less easing ahead, even as easing is still being undertaken today.

Just as the 2013 tantrum finally ended, we believe that this current one will as well. With zero and/or negative interest rates prevailing in a large segment of the developed world bond markets, it seems natural that money seeking positive returns would continue to flow into EM.

The latest data from the Institute for International Finance (IIF) support this view. Total portfolio investment flows to EM have been positive in June, July, and August, and also in 5 of the past 6 months. To underscore just how tough it’s been for EM over the last year, for the first time since December, the 12-month total inflows turned positive in July at $21.3 bln. The 12-month total rose further to $62.2 bln in August, the highest since last October.

Yet we caution investors against becoming too optimistic about EM. Rather than view it as a large monolithic entity, we have long felt that investors must be more discerning, judging each country on its own merits. The global investment climate remains difficult, and now is not the time for complacency.

THE FOUR PILLARS OF EM

From a longer-term perspective, EM and EM investors are coming to grips with the fact that the 10-year boom has ended. What many thought to be a structural improvement in EM fundamentals instead turned out to be a largely cyclical one. We identify four pillars of the decade-long EM rally: 1) Strong global growth, 2) High commodity prices, 3) Weak US dollar, and 4) Low US interest rates. These pillars have eroded or broken down over the past couple of years, causing EM to struggle.

For now, the first two factors, strong global growth and high commodity prices, are not coming back. The latter two, a weak US dollar and low US interest rates, are in flux but should be positive market drivers in the coming months. Notions that the Fed will not hike imminently has tended to be positive for EM in the course of this year, and it’s clear that the pace of tightening will be very modest.

A purely liquidity driven model of investing will work....until it doesn’t. Conversely, EM and risk have typically come under pressure when prospects for Fed tightening rise, such as the run-ups to FOMC meetings and speeches by Fed Chair Yellen. So even though we do not see the next Fed hike until December, EM is likely to come under some periodic pressures in the coming months. Those EM countries with the weakest fundamentals will suffer the most.

IT’S THE POLITICS, STUPID

High commodity prices translated into strong economies and fundamentals during the boom years, and helped mask many underlying problems. The end of the boom has led to deteriorating fundamentals, laying bare many fault lines in EM. While commodity exporters have been hurt across the board, it’s no coincidence that many of the worst-hit countries have been the ones with the most dysfunctional political systems.

The failed coup attempt in Turkey has already led S&P to quickly downgrade its rating to BB with a negative outlook. This is where our own sovereign rating model rates Turkey, but we see further downside risks. The coup attempt has led to huge purges of the Turkish military, judiciary, press, and academia. As President Erdogan deepens his efforts at exerting complete control over the nation, the economic outlook will continue to worsen.

Moody’s recently cut Turkey to a sub-investment grade Ba1. The loss of investment grade will likely lead to forced selling of Turkish assets, since many investment mandates require at least two investment grade ratings in order to be investible. Note that S&P never had Turkey at investment grade, but downgraded it a notch this summer to BB. Fitch should eventually follow suit and downgrade Turkey to BB+ as well.

Elsewhere, South Africa faces a similar dynamic. We believe that the recent local election losses for the ruling ANC will be positive in the long-term, but negative in the short-term. The rise of a legitimate opposition party is a good development, but the ANC’s dwindling support may lead it to follow more populist policies ahead of the 2019 national elections.

This is likely to tip the nation into sub-investment grade territory. It is currently hanging on to its BBB-/Baa2/BBB- ratings. The country’s fundamentals are already weak, and a combination of a larger budget deficit and rising debt loads would likely push the ratings to sub-investment grade.

Brazil has already faced tremendous selling pressures, deep recession, and the loss of its investment grade status. As such, the worst may be behind it. The road to recovery, however, remains elusive, despite the turn in sentiment. The recent expulsion of lower house chief Cunha has raised concerns that he will implicate members of the Temer administration.

Brazil asset prices are pricing in perfection: that is, that the Temer government successfully pushes through structural reforms and the economy recovers as the central bank cuts rates. These developments are by no means assured. The Temer government is already getting some pushback on its plans to freeze spending, and we believe an unelected government will simply reach the limits of what it can actually do. The next elections aren’t until 2018. Meanwhile, inflation remains stubbornly above the 3-7% target range, and could prevent a rate cut next month.

Despite the concerns that we’ve cited, yield-hungry investors have bought up higher yielding assets in Brazil, Turkey, and South Africa this year despite these countries having what we view as very weak fundamentals and underlying political fissures. When market sentiment worsens, these three are likely to come under the greatest pressure.

In the current environment, we feel most comfortable with Asia. China has been the source of market instability at times for the market, but not lately. Indeed, investors appear comfortable with the slowing growth scenario for the mainland economy.

Elsewhere in the region, both India and Indonesia have recently been able to advance their reform agendas. The introduction of a national goods and services tax (GST) is an especially noteworthy development. Both have large domestic markets and so are less vulnerable to the global growth slowdown than the more export-oriented EM economies. More importantly, India and Indonesia have benefited from having reformers at the helm.

Malaysia stands out in the region as being one of the riskier stories, and this too can be chalked up to political concerns. Prime Minister Najib has so far avoided direct implication in the 1MDB scandal, but ongoing investigations by the US, Switzerland, and Singapore warrant some caution.

Besides Turkey and South Africa, several other countries in the EMEA region are subject to downside risks stemming from bad politics. Hungary and Poland both have governments that can be considered to be less market-friendly than prior ones. Poland is also under downward ratings pressure as a result. Furthermore, Poland faces possible EU sanctions due to a “systematic threat to the rule of law” by the ruling Law and Justice Party.

Latin America has improved in terms of politics. Impeaching Rousseff in favor of a more market-friendly government can be seen as a positive development. However, it is not a magic bullet as Brazil faces a variety of challenges ahead. Elsewhere, Argentina elected a government that is committed to reversing the harmful policies of the Kirchner/Fernandez years. Chile, Colombia, Mexico, and Peru have all suffered from lower commodity prices, but good governance during the boom years has given these countries a cushion to rely on.

Some potential problem countries in the region are Bolivia and Venezuela. In Venezuela, the situation has turned into a tragedy. Wealth accumulated from the oil boom years is long gone, and citizens cannot get the most basic needs of food and medicine now. The opposition took control of the congress last year and is pushing for a recall referendum, but President Maduro shows no signs of relinquishing control of the country. Default risk remains elevated.

In Bolivia, President Morales lost a constitutional referendum in February that would have allowed him to run for a fourth consecutive term. His current term ends in 2020, but we suspect that we have not seen the last of his efforts to extend his rule. Meanwhile, Bolivia continues to struggle under the weight of lower oil prices. Fitch recently downgraded it a notch to BB-, and further downgrades are possible.

Unfortunately, in Mexico recent developments warrant caution. The invitation to invite Donald Trump to Mexico was a bad decision by President Peña Nieto. It generated outrage and has ignited protests calling for his ouster. It also reportedly led to the resignation of Finance Minister Videgaray. The possibility of a Trump presidency has led some to fret about the fate of NAFTA as well as US-Mexico relations in general. This too bears watching.

CONCLUSION

It’s clear that EM as an asset class can still thrive even under difficult global conditions. It is equally clear, however, that not every EM has the institutional stability that is often required for long-term prosperity. As the economic backdrop remains weak, the political element becomes a very important determinant for a country’s trajectory going forward. Again, it’s the politics, stupid.