We believe the Fed is on track to hike at least three times this year. Yet EM currencies were mostly firmer in Q1, despite Fed tightening typically being very disruptive to EM. Why? The US dollar lost some traction as markets pushed out Fed tightening beyond March and Treasury Secretary Mnuchin seemed to push out fiscal stimulus into 2018. Rising commodity prices also helped buoy EM.
Below, we discuss the four major pillars of an extended EM rally, and why they remain elusive in 2017: 1) low US interest rates, 2) a weak dollar, 3) strong global growth, and 4) high commodity prices. For the most part, we believe a lasting EM rally will prove to be elusive in 2017.
Of these factors, the first and second appear to be shifting most. The Fed appears comfortable hiking rates this year even with the unknown magnitude and impact of fiscal stimulus. Given the monetary policy divergences still in play, we believe the broad-based dollar rally will continue this year.
Global growth, while picking up, remains well below historical norms. The IMF forecasts global GDP growth of 3.4% in 2017 and 3.6% in 2018, up from an estimated 3.1% in 2016. Global growth averaged 5% in the five years preceding the Great Financial Crisis. Global trade volumes are expected to rise 3.8% in 2017 and 4.1% in 2018 vs. an estimated 1.9% in 2016. Yet these rates are also below what can be regarded as historical norms.
The tailwind from higher commodity prices appears to be fading as new supply comes on line in a variety of markets. Copper stockpiles measured by the London Metal Exchange recently rose by the most in 15 years, with Asian warehouses seeing the biggest builds. Oil prices have recently dipped to pre-OPEC cutback levels, as output from the US looks set to increase in the coming months. The Baker Hughes oil rig count rose to 617 in mid-March, up 60% y/y and the highest since September 2015.
From a regional perspective, we believe Asia and EMEA will fare the best in 2017. Both regions are largely facing accelerating inflation that will require policy responses. Fortunately, the growth outlooks are mostly improving in Asia as the mainland China economy perks up, so these economies are likely to be resilient in the face of monetary tightening. Their currencies should also be helped by higher interest rates.
In EMEA, most countries are also experiencing higher inflation and robust growth that should push their central banks into a less dovish stance. Czech Republic should end its CZK floor by mid-year, while Poland may find it hard to stick to its pledge to keep rates at current lows until 2018. South Africa is the major exception in this region, as the weak economy and high unemployment could push the SARB into an easing cycle before year-end.
Latin America faced rising inflation last year that required monetary tightening for most countries. This year should see continued unwinding of that tightening cycle. Brazil, Chile, and Colombia have already started cutting rates, while Peru is poised to start sometime this year. The major exception is Mexico, where rising inflation and a weak currency will likely keep the central bank in hawkish mode. If commodity prices continue to soften even as monetary policies are loosened, then Latin American currencies appear likely to underperform with EM this year.