1 March 2018
Emerging Market investing is a lot more complicated than it used to be — and not just because it is difficult to replicate last year’s stellar performance. Prior to the Global Financial Crisis (GFC), EM’s superior growth prospects garnered investors’ attention. In addition, EM growth and inflation cycles tended to be in sync, and capital inflows easily met the financing needs of these nations. The GFC put an end to that comfortable world. Individual EM countries were impacted by and reacted differently to the crisis. As a result, the degree of idiosyncratic risk in individual markets is greater than ever. In other words, the importance of sovereign risk analysis has never been greater (something to bear in mind as you consider your research budgets post MiFid2!!).
Furthermore, rising US interest rates have posed a headwind for EM investing in the past cycles. So far, the emerging markets have shrugged off the commencement of US monetary policy normalisation. How long will this last? Again, the answer will depend greatly on the circumstances with individual countries. It will pay to do your homework!
EM Business Cycles: The Path to Neutral Monetary Policy
One of the key attractions of Emerging Markets always has been the superior economic growth offered compared to developed markets (DM). Chart 1 (at the top of the blog), however, illustrates that as in the DM countries, the trend in the long-term GDP growth has slowed in nearly all EM nations during the past decade (with the possible exceptions of the Philippines, Indonesia, India, and Turkey). As is true elsewhere, EM’s diminished long-term growth prospects probably reflects slower productivity growth and higher debt levels, which are the legacy of the GFC. As a consequence post-crisis capital inflows into emerging markets have remained well below the earlier halcyon days. In order to enjoy again the level of pre-crisis capital inflows, therefore, many Emerging Market countries will need to implement structural reforms to lift productivity trends to earlier levels (a theme playing out world-wide).
An additional legacy of the GFC has been that the business cycles across the EM universe are more misaligned currently than in the past. The crisis impacted the economies of individual EM countries differently. As a result, EM policymakers responded to the crisis with divergent monetary, fiscal, and FX strategies. Not surprisingly, therefore, EM economies currently are at varying stages in the growth, inflation and interest rate cycle.
Chart 2 and 3 will help identify where individual countries/regions are in business cycle: important considerations for both investors and EM central banks. In Latin America, for example, while growth prospects in the region are generally on the mend (most importantly, Brazil finally has emerged from its deep recession), GDP growth remains below the area’s long-term potential, and considerable slack remains in the economies. As a result, Chart 2 illustrates that inflation is still declining, and that price pressure will remain modest in the period ahead. This is true, even in Mexico, as the impact of the earlier MXN depreciation is fading.
Under these conditions, one would expect monetary policy should be accommodating, or neutral at worst. Chart 3, however, illustrates that financial conditions in both Brazil and Mexico are more restrictive than warranted at this stage of the economic cycle. Mexico has been tightening monetary conditions (as recently as one week ago) in order to limit the inflationary impact of MXN’s depreciation. As inflation is now peaking, I expect Banxico will reduce interest rates 100bp during the 12-18 months, even as US rates rise (timing will be impacted by the outcome of upcoming Presidential election). Likewise, while Brazil has hinted recently that interest rates may have bottomed, I anticipate that persistently low inflation will prompt the BCB to ease monetary policy up to an additional 150bp during this cycle.
With growth below trend and inflation low, monetary authorities in both Chile and Colombia will maintain an accommodative stance this year — keeping interest rates below the “neutral” level.
In EMEA, likewise, countries are at widely varying stages in the economic cycle, and the appropriate monetary stance will differ accordingly. In particular, despite its nascent economic recovery, considerable slack remains in the Russian economy, and inflation is declining sharply. However, Chart 3 illustrates that the deviation of Russian monetary policy from “neutral” is the largest in the EM universe. Russian interest rates could decline up to 300bp.
On the other extreme, Turkey’s economy is overheating: growth is above trend, inflation is rising, and the current account deficit is widening. However, monetary conditions remain too relaxed to meet these challenges – interest rates may need rise beyond the neutral setting. Specifically, Turkey will need to hike rates at least another 100bp to curb price pressure and restore lost policy credibility.
Meanwhile, the new South African government inherits below-trend GDP growth, declining inflation, and scandalously high unemployment. Nevertheless, interest rates are above the neutral level. Following the ZAR’s rebound and the recent announcement of a tough budget stance, I expect the SARB will be able to reduce interest rates 100bp.
Within this wide regional mix, Poland and Hungary lie in between the extremes. In both cases, GDP growth is running above trend, inflation remains comfortably below targeted levels, and monetary policy remains accommodating. With the Polish GDP expanding over 5%, monetary policy normalisation appears appropriate. However, there is no rush, as inflation is merely 0.9% (target 2.5%) and unemployment nearly 7%. Nevertheless, I expect Poland to raise rates (Q4 2018 perhaps) prior to the ECB in 2019. Arguably, there is more slack in Hungary’s economy, as GDP growth has lagged considerably Poland’s during this cycle. While this suggests rate hikes may come later than their neighbour’s, Hungary’s monetary policy is more accommodative, unemployment lower, and inflation already higher than in Poland.
Meanwhile, Chart 3 indicates Asian monetary conditions uniformly are the most accommodating within the EM universe. With growth above trend in all countries, central banks eventually will begin removing some stimulus. However, low inflation suggests that excess capacity remains. Consequently, the process of interest rate normalisation will be very deliberate and cautious, and will continue to lag well behind the US Federal Reserve. Interest rate differentials will continue to widen. India, the Philippines, and Indonesia, however, are likely to move before Thailand, Taiwan, and Korea.
Exchange Rates: Follow the Flows
The GFC was also characterised by numerous bouts of significant exchange rate volatility. Chart 4 illustrates the extent current exchange rates deviate now from their long-term averages (“fair” values). As with business cycle misalignment, the GFC has led to a wide disparity in real exchange rates: INR and PHP are nearly 10% overvalued, while MXN and TRY are 15-20% undervalued.
In the past, rising US interest rates often posed a headwind for the EM currencies. The countries faring worst were often those characterised by large external borrowing requirements — the sum of current account balances, short-term external debt, and debt amortization. As US interest rates rise, such countries often find it more difficult to attract the foreign capital to meet these funding needs. Chart 5 compares the external financing requirement to each nation’s current holding of international reserves.
What conclusions can we draw? The Mexican peso is the cheapest currency in the EM universe, largely reflecting NAFTA and domestic political risks. MXN has not been this cheap since the 1994 Tequila crisis. The timing of both Mexican and US elections this year suggests that any MXN recovery may take time, but eventually I expect MXN/$16. On the other hand, Brazil’s financing needs appear relatively manageable, and consequently the BRL has been able to rebound during the past two years. In the run-up to the October election, unattended fiscal deficits and unstable debt dynamics will be the key source of potential FX volatility, especially as BCB’s priority will be to reduce interest rates. In Chile and Colombia, ultra-low interest rates and above average financing needs could make CHL and COP vulnerable as the Fed hikes rates.
EMEA is again a region of extremes. Despite chronically weak growth, the Russian ruble may be relatively immune to rising US rates, as immediate external financing needs are minimal, inflation is collapsing, and oil prices have firmed. At the other extreme, Turkey confronts rising inflation and EM’s large funding need. Even though TRY is cheap (not having enjoyed the rebound of ZAR and BRL), risks remain high. Meanwhile, despite a relatively large external funding need, I expect the Polish zloty to outperform (target Eur/PLN 4), as Poland tightens monetary policy prior to both the ECB and Hungary. HUF could surprise, as Hungary’s external position has improved in recent years.
South Africa’s vulnerability lies less with a large borrowing need, but rather from its low level of international reserves and capital inflows, which do not provide much of a cushion as US rates rise. After the recent recovery, ZAR is no longer hugely undervalued. Upside is limited, as SARB’s priority will be to lower interest rates.
Tigher Fed policy is a headwind for Asian currencies, especially as Asian interest rates will remain low. However, very low external financing requirements provide an ample cushion, especially in THB, TWD, and KRW. I expect some modest weakness in overvalued INR and PHP. China’s external needs are modest. Instead, potential CNY volatility would stem from capital outflows, if local investors reconsider the sustainability of high domestic debt levels (a replay of 2015). US monetary policy decisions will not have a large role in that story.
Strategic Implications
- So far, EM FX has been immune to rising US rates. Market volatility may increase in H2 2018, after the Fed funds rate exceeds 2% (becomes positive in real terms).
- Strong growth, low inflation, and easy monetary conditions favour Asian equities versus the USA.
- Overvalued INR and PHP will decline. THB and TWD should outperform.
- Good fixed income opportunities exist in Russia, Brazil, Mexico, and South Africa.
- FX upside exists in MXN and PLN (HUF could surprise).
- Avoid Turkey: bonds, TRY, and equities! Markets cheap, but CBT must restore credibility.