The second half of Q1 has seen a bit of a recovery from the emerging markets (EM) weakness seen in 2015 and early Q1, with the latest bounce taking place after the FOMC meeting. Still, we believe that the four pillars of the cyclical EM rally remain badly damaged. From 2002-2012, EM benefitted from a weak dollar, low US interest rates, strong global growth, and high commodity prices. Over the last couple of years, those pillars collapsed. Now, EM is trying to regain some traction as some of those pillars are undergoing repairs.
To us, however, any improvement of these broad conditions is likely to prove temporary. Indeed, we believe that
- The broad-based dollar rally remains intact,
- US interest rates will head higher as the Fed tightening path is likely to resume,
- global growth remains sluggish, and
- commodity prices are still facing supply-demand imbalances.
What are some of the factors feeding into this corrective bounce for EM? The European Central Bank (ECB) and the Bank of Japan (BOJ) are still in easing mode for the next 1-2 years. The People’s Bank of China (PBOC) eased again on the last day of February, and more easing is expected in 2016. The Bank of England (BOE) lift-off continues to be pushed out further into 2017. Lastly, Fed tightening expectations are being pushed back after the March FOMC meeting, when the Fed was perceived as being too dovish. Taken together, we believe that the global liquidity backdrop remains supportive for EM and risk for the first half of Q2.
We think that the market view on Fed policy has become too dovish, however, and this is likely to be the source of the next round of EM weakness as Q2 progresses and the June 15 FOMC meeting approaches.
If and when Fed tightening expectations are finally adjusted upwards, this will likely prove stressful for EM. This was the dynamic we saw in the run-up to the March FOMC meeting. Longer-term, we remain cautious on EM and urge investors to use any bounces to rebalance portfolios and to hedge, whenever possible.
If there is a mid-year selloff as we expect, EM could gain some traction late in H2 or early 2017 if the Fed can manage market expectations and volatility. Even with the Fed tightening, the pace will likely remain slow and measured. Therefore, developed market (DM) interest rates, while rising, will still remain relatively low compared to EM interest rates.
Global growth remains sluggish. While the IMF cut its 2016 and 2017 growth forecasts in January to 3.4% and 3.6%, respectively, we think downside risks prevail. Indeed, it’s hard to make the case for much acceleration from the estimated 3.1% global growth posted in 2015.
With regards to the commodity space, most analysts believe that supply-demand imbalances across the major groups (energy, industrial metals, and agriculture) will persist this year. This will likely prevent too much of a price recovery in 2016. However, as 2017 comes into view and the supply-demand dynamics change, we should see commodities move even higher. This would be positive for EM.
Within EM, country-specific risk remains in play. This argues for continued differentiation within EM as an asset class. Brazil, South Africa, and Turkey are likely to benefit from an extended EM bounce, but these credits will likely be sold off the hardest when sentiment turns negative again. Below, we discuss the outlooks for the major EM countries.
Brazil fundamentals have been worsening with a toxic mix of heightened political risk, ongoing recession and institutional paralysis.
Inflation pressures remain high, and IPCA inflation remains well above the 2.5-6.5% target range. The weak real should boost imported goods prices. Electricity charges will stay at high levels due to subsidy cuts to electricity firms while the minimum wage is likely to continue increasing from indexation.
The Brazilian economy continues to contract: Q4 GDP dropped 5.9% y/y, the worst since 1996. IMF forecasts Brazil will contract by 3.5% in 2016 and remain flat in 2017. The upcoming summer Olympic Games could support the economy, but some construction has been canceled due to lack of funding, and the spread of Zika virus will likely hurt tourism.
The central bank shifted its stance to dovish while inflation pressures have been high. It left rates at 14.25% since July 2015. Some expect the bank to cut rates once inflation slows, but for now, the bank needs to keep rates steady due to high inflation pressures.
Brazil’s fiscal condition has not improved. The 12-month total government primary budget deficit fell to BRL 104.4 billion in January from BRL 111.2 billion in December, but this was due to one-off factors. The government backtracked on its primary surplus target for 2016, instead requesting Congress to approve a -0.5% of GDP deficit. Worsening economy and political dysfunction should disturb the fiscal reform.
Moody’s cut Brazil’s sovereign rating by two notches to Ba2 with a negative outlook. All three agencies put Brazil at sub investment class. Moody’s caught up with S&P’s BB, with Fitch now the outlier at BB+. BBH’s sovereign ratings model has Brazil at BB-/Ba3/BB-, which suggests further cuts are warranted. Given the downgrade to junk, the Brazilian government and Congress may abandon fiscal reform as they may feel they have nothing left to lose now.
Lastly, the political situation remains fluid. However, it appears Lula and Rousseff both remain very vulnerable due to the on going corruption scandal. Anti-government protests have intensified, and these developments raise the odds of impeachment and political exile for the PT (Workers’ Party), which many see as a long-term positive for Brazil. However, with Rousseff offering the post of Chief of Staff to Lula, we do not think either will go quickly or quietly. A protracted battle could see economic policy deteriorate.
The Indian government released the budget plan in FY 2016, which signals that the government continues to maintain its two main policy objectives: increasing capital investment while maintaining fiscal restraint.
The fiscal deficit would narrow from 3.9% to 3.5% of GDP, the smallest since 2008. The deficit is forecast to narrow to 3% of GDP in the following two fiscal years. The revenue plans seem too optimistic with an 11% rise, more than the average during the past three years, as new tax plans could be hobbled by opposite parties. Expenditures are expected to rise by 15%, about triple the average over the past three years, which suggests the government needs to take into account the growth ahead of state elections in 2016 and 2017.
Modi has yet to live up to expectations regarding structural reforms, but the pace of reform will be slow and incremental. Indeed, if revenue is weaker than expected, fiscal reform could stall.
Inflation pressures have been inching up. January CPI rose to 5.69% y/y, close to the top of the 2-6% target range and the highest since August 2014. A weak rupee could offset low oil prices and so the Reserve Bank of India (RBI) may remain cautious about further easing.
Indian growth remains robust as Q4 GDP grew at 7.3% y/y, this makes three consecutive quarters over 7%. Private consumption has supported growth while business investment has slowed. With a small share of exports to GDP (at around 15%), the Indian economy is well-placed for an environment of slow global growth. But relatively high yields and persistent inflation pressures could limit private demand.
The external accounts remain in good shape. Lower oil prices have helped reduce imports, and this has outweighed downward pressure on exports. The current account gap is expected to remain virtually unchanged near -1.5% of GDP in 2016. Foreign reserves stand near record highs around $329 billion in February.
Bank Indonesia (BI) continues to ease monetary policy as it cut the policy rate from 7.50% to 6.75% over the course of the past three meetings. Low price pressures could encourage BI to ease more in 2016 due to weak growth. Inflation continues to ease to 3.62% y/y in February thanks to low oil prices and base effects.
The Indonesian economy remains sluggish. GDP growth continues to decelerate and growth in 2015 was 4.8% which is the lowest since 2009. BI sees GDP growth accelerating to around 5% in 2016 and nearly 6% in 2017, but recent data suggests downside risk has strengthened.
Indonesian external accounts have been in decent shape as the current account deficit is expected near 2% of GDP in 2016. Low oil prices and weak domestic demand have led to weak imports.
Fiscal policy is a not a big concern — yet. The budget deficit is expected to narrow to around -2% of GDP in both 2016 and 2017. However, there are upside risks given sluggish growth as well as Jokowi’s plans to stimulate growth via infrastructure spending.
The rupiah has outperformed but it remains vulnerable due to weak fundamentals. Indonesia still depends heavily on foreign inflow and foreign reserves have been falling steadily. President Jokowi is pushing for more rate cuts, but too much easing risks driving away foreign investors.
The Mexican economy remains sluggish although it should benefit from steady US growth. Q4 GDP grew by 2.5% y/y and it is expected to grow by around 2.5% in 2016 and around 3% in 2017. But the real sector has been softening and we see a downside risk to these growth forecasts.
Exports in both petroleum and non-petroleum have weakened. Total exports fell by 7.6% y/y, which makes seven straight months of decline. Overseas worker remittances continue to increase on steady US economy and supports private consumption.
Inflation pressures are picking up due to low base effects and the weak peso. Headline CPI accelerated to 2.61% y/y in January from +2.13% y/y in December. Core CPI in January rose 2.64% y/y, the highest since December 2014, but inflation pressures could remain subdued. The Banco de Mexico sees inflation to be slightly above 3% in Q2 and Q3 but slowing to near 3% at the end of 2016.
The Banco de Mexico surprisingly hiked rates by 50bp to 3.75% in an interim meeting. Governor Carstens mentioned that volatility in global markets had risen since the last meeting and so the bank intervened in the FX market. In addition, the FX commission announced that it was discontinuing the regular auction program whilst maintaining the possibility of further discretionary dollar sales. This news suggests that Mexican officials are trying to maintain confidence in the peso in order to stem any inflationary pass-through from a weak peso.
The government maintains fiscal austerity in the face of low oil prices. It announced a spending plan that will cut expenditures by MXN 132.3 billion in response to low oil prices and weak growth. Finance Minister Videgaray said preventative cuts were needed to meet the budget targets. Mexico fiscal austerity should secure credibility in the markets and support the peso.
However, the peso remains fragile due to unclear global situations despite good fundamentals. The peso still has strong correlation with oil prices and has been considered as a proxy for EM. Foreign reserves remain under pressure, falling to $174.7 billion in January. That’s above the recent low near $171.9 billion from November, but not by much.
The Russian economy has contracted as GDP in 2015 dropped 3.7% y/y, the first contraction since 2009. Lower oil prices and economic sanctions by US and Europe continue to worsen its economy. The World Bank forecasts the Russian economy contracted 0.7% in 2016.
Inflation pressures continued to slow, reaching 8.1% in February, the smallest since September 2014. The central bank has kept rates at 11.00% since the last 50bp cut back in July, but Governor Nabiullina said it does not rule out tightening monetary policy if needed.
Lower oil prices have led to a deteriorated Russian fiscal condition. Oil and gas related taxes account for approximately half the Russian federal government’s revenue. Russian Finance Minister Siluanov said fiscal expenditure should be cut by 10% in order to cover a budget shortfall in the event oil averages $30 a barrel in 2016. Some big Russian state owned firms, such as Aeroflot and Rosneft, could be privatized to compensate for decreases in revenue due to low oil prices.
Russian officials need to monitor the ruble carefully as a weak ruble should lead to higher inflation and capital outflow. Nabiullina said the central bank is worried about heightened FX market volatility and would intervene in the market if financial stability is threatened.
South Africa is on the verge of being downgraded to sub-investment grade. The government pledged to improve the budget deficit to -3.2% of GDP in FY16/17 and then -2.8% in FY17/18. Some government revenues would be raised by hiking taxes on capital gains, property sales, fuel and alcohol/tobacco, as well as launching new taxes on vehicle tires and sugar-sweetened drinks. The government also plans to reduce spending targets by cutting civil service jobs while some controversial reforms such as the Value Added Tax (VAT) or privatization of state owned companies were deferred.
But, South Africa’s economy remains weak. Q4 GDP rose 0.6% y/y, the lowest in the past six years. The government cut its growth outlook to 0.9% from 1.7% in 2016 due to depressed global conditions and the impact of the drought. Weak growth should enhance downside risks to government revenue and make it more difficult to cut expenditures.
Tensions between Zuma and Finance Minister Gordhan remain high. If Gordhan is forced out, we think that investors would give up on any hope of orthodox policies from Zuma. Whatever happens, the nation’s reputation has been greatly damaged. On the other hand, there is a growing perception that the latest revelations regarding corruption could lead to Zuma’s exit. That is not our base case, however, as his power base within the ANC is thought to be strong. As such, Zuma could muddle through again.
The rating agencies have warned the budget plan is not credible, given persistent weak growth. Our own ratings model has South Africa at BB/Ba2/BB. Both S&P and Fitch put the country at BBB-, the lowest investment grade, and S&P has a negative outlook.
Inflation remains high, above the upper end of the target range. As a result, the South African Reserve Bank (SARB) continues to hike rates to 7.0%, the highest since early 2010. Lower oil prices have not helped to ease pressures, with the weak rand and supply constraints due to failure of power plant and severe drought. High inflation could also encourage the rating agencies to cut the rating to sub investment grade.
The Korean economy remains sluggish as Q4 GDP rose 3% y/y and growth in 2016 and 2017 is expected at around 3%, almost the same as 2013-2015. External demand continues to worsen and domestic demand has shown signs of weakening. The slow global economy and stalled government stimulus would strengthen downside risks to the growth forecasts.
Headline CPI has been low at 1.3% y/y in February, below the 2.5-3.5% target range, because of lower oil prices and slow growth. Core inflation was 1.8% y/y in February, the lowest since December 2014.
The Bank of Korea (BOK) has kept rates steady at 1.5% since June 2015, but they are likely to be considering rate cuts in 2016 after lowering their growth and inflation outlook. However, recent won weakness has made the BOK cautious.
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 seen at around 7% of GDP in both 2016 and 2017, down slightly from 8% in 2015.
South Korean fundamentals such as low inflation pressures and solid external accounts should continue and should support the won. Moody’s upgraded Korea one notch to Aa2 with a stable outlook and BBH’s sovereign rating model put South Korea at AA/Aa1/AA.
Inflation pressures have strengthened as core CPI rose to 9.72% y/y in January, the highest since July 2014, and headline CPI remains above the 3-7% target range. Low oil prices have not helped inflation pressures ease due to the weak lira. The increase in minimum wage by 30% should boost inflation and inflation expectations.
Due to high inflation, the central bank should hike rates but it has kept rates at 7.50% since February 2015. Governor Basci’s term ends April 19, and a more dovish replacement will likely be named by the government, which has requested the bank to cut rates.
The Turkish economy remains sluggish. GDP growth in 2016 is expected by the IMF at around 3% while the Turkish government forecasts for 4.5%. Q4 GDP may rise over 4% after holding steady at 4% y/y in Q3, but Q1 growth has likely slowed with Russian sanctions and heightened geopolitical risks.
The Russian government expanded its sanctions against Turkey -- barring new Turkish construction and curbing tourism activities in Russia with banned food imports. Suicide bombings and terrorism continues as the peace process with the Kurds collapsed. Public security in Turkey has deteriorated and Turkish tourism has contracted. Turkey foreign tourist arrivals continue to drop for 6 straight months as it decreases by 6.4% y/y in January. High inflation and unemployment could stall private consumption as well.
The external accounts are in decent shape but are not expected to improve more. Turkey exports continue to decrease, even with a weak lira, as January exports dropped 22% y/y, the biggest decline since September 2009. Russian sanctions should worsen the external account through agricultural exports and tourism.
The lira remains fragile due to current account deficits and short term external debt. Turkey short term external debt continues to decrease to $115.6 billion at the end of 2015. However, it is 122.5% of its foreign reserves, which have fallen to $92.9 billion in January, the lowest since July 2012. Usable reserves, which net out commercial bank foreign currency deposits at the central bank, have fallen to a meager $23 billion.