Once again, investors have been unsettled by emerging markets in recent months. The political tensions between Russia and Ukraine, coincided with a modest slowdown in economic activity in several emerging markets. But there are signs that emerging markets could be stabilising over the coming period. This is mainly due to the countercyclical policies in many emerging markets and prospects of a stronger global economy. Indeed, the Fed’s tapering has been comfortably digested and political risks are now largely priced in. We expect GDP growth to pick up modestly to 4.7% in 2014 and 4.8% in 2015.
Stress from the East not completely over…
Just as calm has returned to emerging markets after the summer’s turmoil, a new string of unexpected developments put them back in the spotlight. The escalation of strains between Russia and Ukraine, coupled with political tensions in Turkey and a slowdown in China were weighing on sentiment towards emerging markets. Not everything is resolved, and there will likely be some stress down the road, but investors have put most of these events behind them. The dispute between Ukraine and Russia intensified after Russia’s annexation of Crimea, which triggered a number of sanctions against Russia. Tensions remain elevated in Eastern Ukraine, and the economic impact for both countries is now materialising. Meanwhile, the IMF has pledged to support Ukraine with a USD 14-18bn loan over two years as part of a broader financial support programme. It appears that the full spectrum of Ukraine’s political parties are ready to carry out the necessary reforms in exchange for support, suggesting that there is commitment to reforms, independent of the political background. In Turkey, meanwhile, political strain was also growing in the run-up to the local elections, which were depicted as a referendum on the Prime Minister’s administration. His party’s victory should mark a turning point in a period of uncertainty.
In China, first-quarter data was weaker than we expected. China’s financial sector reform and efforts to deleverage are weighing heavily on confidence and have, to some extent, contributed to the loss of momentum in economic activity. Market participants have become unsettled about the ability of China’s leaders to reduce the risks of shadow banking while keeping their growth target on track. Specific events, including the near default of a trust fund, the less regulated activities of shadow banking and the first default of a mainland corporate, have raised concerns of a hard landing. Commodity markets felt some of the downward pressure mainly led by uncertainty earlier in March, but are now recovering. The impact of the slowdown in commodity prices on exporting countries has so far been limited. And in any case, it is clear that Chinese authorities will support the economy in order to reach the growth target of around 7.5% in 2014. China has many tools to trigger a cyclical rebound. Fiscal loosening is not a constraint. Indeed, the announcements of a new round of stimulus in early April and plans for a new type of urbanisation to boost investment in infrastructure were positively embraced by markets.
…while stress from the West is being tackled with policies
In Latin America, there were signs of a slowdown in economic activity in the first quarter. Mexico, Brazil, Chile and Argentina are showing somewhat sluggish domestic demand. Challenges to the region’s recovery are daunting and several countries are in the process of implementing structural reforms. Mexico has chosen ambitious reform strategies to transform its economy and has been rewarded by an upgrade of its sovereign debt by Moody’s in February to A3 from Baa1. Nonetheless tax hikes in January and the severe winter in the US were some of the factors that have kept the economy somewhat depressed. Mexico will have to work on its reforms to convince investors about the outlook since monetary easing is not really an option given the normalisation of monetary policy in the US. Meanwhile, Argentina has cut some subsidies on gas and water and Venezuela has devalued the bolivar. Brazil had been continually hiking interest rates since April 2013 to reduce inflation pressure though it has signalled that interest tightening is over. In March, Standard and Poor’s downgraded Brazil by one notch to BBB- just above the “junk bond” rating, signalling that fiscal credibility has weakened. Investors are demanding that the region increase the pace of reforms to put their economies in order.
Sentiment gradually improving
Policy measures, including interest rate hikes and − in some cases − fiscal consolidation, are currently weighing on economic activity. Still, market sentiment has been gradually improving on the prospects of stronger economies in the long run. Foreign exchange and stock markets are responding positively. India seems to be the strongest of the so-called “fragile five” . The country has made a sustained improvement in the trade balance and the PMI (Purchasing Manager’s Index) has been trending upwards. The improvement in the trade balance is due to slower import growth resulting from the gold import ban and weaker domestic demand. Indonesia’s trade balance has been strengthened on the back of a reduction in oil subsidies and interest rate hikes. In Turkey, the trade balance is also gradually improving, mainly driven by a decline in gold and energy imports, while the effects of the recent interest rate hikes should still be felt in the coming months. Meanwhile, Russian markets which had strengthened somewhat in the past weeks have again reverted. A 150bp rate hike was implemented in the midst of the crisis in an effort to ease capital outflows.
Outlook: after the dip
For several reasons, we are confident that economic growth in emerging markets will gradually firm. First, the US and Europe are on track in their recovery process. This means that the positive momentum should spread to emerging markets. In fact Taiwan and South Korea, which are considered the economies leading the cycle in the region, are already showing a rebound in exports. Second, capital flows have found their way back to emerging markets. However, we are more cautious on this. As we have already pointed out on several occasions, the composition of capital flows is likely to make some emerging markets sensitive to global financial conditions. The share of bond issuance has increased and this can become a new source of instability, in some countries like Malaysia, Mexico and Poland. The progress that these countries are continuing to make in adjusting their economies to achieve more solid growth will be important. After all, volatility can’t be ruled out in the adjustment process emerging markets are currently experiencing. Elections in Turkey, India and Indonesia will provide opportunities if, as we expect, the newly elected governments present a more solid base. In Latin America, election risks are contained. We don’t think that elections in Brazil and Colombia will be game changers. We expect growth in the region to increase to 2.8% of GDP in 2014 from 2.4% in 2013. Meanwhile, the negative developments in Russia and Ukraine will drive down growth in emerging Europe. In our base scenario we expect a modest deceleration of regional growth this year, to 1.6% (from a post-credit crisis low of 1.7% in 2013). As for Asia, we expect growth to remain unchanged compared to 2013 at 6.1% in 2014. We think that export growth will be an important driver for Asia’s growth as a result of the recovery in advanced economies.
Risks to the outlook
Downside risks have so far been contained. Investors have already digested the Fed’s plans and have priced in political risks in emerging markets. However, we could still see some volatility ahead of the normalisation of interest rates in the US, particularly in the most vulnerable emerging economies. Moreover, as the Chinese economy migrates towards better quality growth and deleveraging is unavoidable, concerns of a hard landing could temporarily weigh on some emerging markets, particularly those that are more reliant on China for their exports. Meanwhile, geopolitical tensions are also lingering, and although they are not part of our base scenario, flare-ups occasionally resurface in regions where conflicts have not been formally resolved. Finally, the impact of the policy adjustments on economic activity in emerging markets is still uncertain and will, in most cases, depend on the underlying strength of the economies. On top of this some emerging markets still have to deal with structural weaknesses. We, therefore, think that we haven’t seen the last of these adjustments. This could make emerging markets more sensitive to changes in sentiment, suggesting that the road ahead is still bumpy.