Emerging market (EM) growth and exports should continue to benefit from slow but steady growth in developed countries. We expect the US economy to decelerate from here as the lagged effect of monetary tightening takes hold and the fiscal boost wears off. Subdued underlying money and credit growth in many EM countries means that inflationary pressures from recent currency devaluations should be temporary, and many EM currencies have stabilised at levels that are helpful for competitiveness. Some of the worst-hit countries such as Turkey and Argentina are undergoing painful recessions which will nonetheless stabilise their external imbalances, while other countries such as Indonesia, South Africa and Mexico are hiking rates in line with the Federal Reserve.
Oil traders were caught-out by sanctions waivers granted to Iran’s key customers, which coincided with a surge in US crude production, but “OPEC+” should eventually respond to stabilise the market. In China, the monetary loosening measures should start to show up in the money and credit aggregates soon, and start to boost activity by the middle of 2019. However, infrastructure investment is still languishing, and deleveraging within the “shadow” banking sector remains a drag. Trump and Xi’s G20 “deal” to postpone the US import tariff hike for three months is unlikely to represent the end of the trade war, although as the economic costs become more apparent over time, both sides will come under pressure to make concessions. If China chooses a weaker RMB, there could be spill-overs to other EM currencies.
The Fed’s balance sheet is now shrinking by $50bn per month, and the ECB’s QE programme will cease by year-end. This will sustain pressure on those countries more dependent on global capital flows to fund fiscal and external deficits. Nonetheless, the key Central Banks’ policy rates remain very low in real terms, supporting the search for yield, and hence EMD from a technical perspective. Recent comments by Fed Chair Powell have signalled that the near-term peak in rates could be close, which would support EM assets. EM sovereign issuance has already reached $140bn year-to-date, so for most countries, financing needs have been met. EM bond fund flows are quiet, and we believe that global investors remain structurally under-allocated to EM credit. After recent spread widening in the high-yield segment, the J.P. Morgan EMBI Diversified Index spread of 395bps is very wide to the post-Lehman’s average, so valuations are attractive.
We see three main risks to the outlook. Unexpectedly strong US CPI or wage inflation in the US could accelerate interest rate hikes, pushing up the USD and leading to a period of volatility for bond and equity markets. The imposition of a 25% tariff on a wider range of US imports from China could lead to a worsening in tensions, hitting confidence and investment expenditure in either (or both) economies. Finally, although not our base case, evidence of further weakness in the Chinese economy, and a weaker RMB, could hit global commodity prices and have knock-on effects in Asia and Latin America.
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