- 2018 was a poor year for non-domestic portfolio flows to EMs …
- … but inflows picked up in Q1-2019 as Fed/US rates turned into a tailwind
- However, another headwind (trade tensions) is back with a vengeance
- All in all, mixed impact on EM capital flows
- We still do not expect widespread recessions nor broad balance of payment problems in EMs
2018 was a poor year for non-domestic portfolio flows to EMs …
In the course of 2018, emerging markets (EMs) were impacted by a rise in risk aversion amongst investors, hitting portfolio capital inflows and causing pressures on currencies, interest rates and stock markets and a general tightening of financial conditions. As highlighted in previous reports (see for instance our EM Watch, Differentation still the dominant theme, published last October), this EM turmoil was driven by several factors. General factors were higher US (policy and market) rates and related dollar strength and the escalation of US-China tensions. More specific factors such as contagion from distress in Turkey and Argentina and other geopolitical factors and sanction threats also played a role. IIF data show that non-resident portfolio flows to EMs dropped sharply during 2018, particularly in the period May-October 2018.
… but inflows picked up in Q1-2019 on more dovish Fed and lower US market rates
A key headwind facing EMs last year was the path of rate hikes by the Fed and the related rise in US market rates. During 2018, the Federal Funds target rate was raised by 100 bps, to 2.5%, while 2 and 10 year US Treasury yields rose by around 100 bps in the same period as well. That softened the search for yield to invest in a riskier asset class such as EMs. This year, however, the headwind of higher US rates has clearly faded. The Fed has been on hold since December 2018 and financial markets and analysts (including us, see below) have started to price in Fed rate cuts, as expectations of a sharper US economic slowdown build. Against that background, US market rates have also fallen again. The Fed pivot and lower US interest rates have benefited portfolio flows to EMs in the first part of this year. According to IIF data, non-resident portfolio flows to EMs trebled in the first quarter of 2019 compared to the two previous quarters.
However, another headwind (trade tensions) is back with a vengeance
However, more recently, the picture has turned once more, as US-China trade and tech tensions have unexpectedly re-escalated since early May and US foreign policy has also become more hawkish versus other countries (particularly Mexico). This was a big negative surprise impacting risk sentiment, hitting affected investors’ appetite for emerging markets. After averaging USD 38 bn per month in January-April 2019, non-resident portfolio flows into EMs as measured by the IIF turned into an outflow of USD 5.7 bn in May, the weakest monthly figure since November 2016 (when Trump won the US presidential elections). Debt inflows fell back to a five-month low of USD 9bn, while equity flows showed an outflow of USD 14.6bn (the weakest figure since June 2013, during the taper tantrum). That said, according to the IIF some recovery of portfolio flows to EMs was visible in early June after the trade tantrum in May.
… which has affected EM financial markets
Financial markets have reacted on the re-escalation of trade tensions, as markets were positioned for some kind of a short-term US-China trade deal without further tariff hikes (and possibly even some contagion). Since Donald Trump tweeted on 5 May that he would raise tariffs on imports from China, EM currencies (including Asian currencies) have generally depreciated versus USD. We should add that the weakness generally was contained and short-lived, as Fed rate cuts are being priced in more strongly. Moreover, some currencies (including in emerging Asia) have been hit more than others. The depreciation of the Chinese yuan versus USD has been relatively limited, partly reflecting PBoC measures to prevent too sharp of a depreciation. The potential impact of the trade conflict on China/Asia centered supply chains was also visible in equity markets. After a strong performance of Asian stock markets since the Trump-Xi truce of December 2018, Chinese and other Asian stock markets tanked on the re-escalation of the trade conflict in early May.
Looking ahead: we have moved towards a more negative scenario
On the basis of recent developments, we have shifted our base case to an ongoing escalation of the trade conflict between the US and China/Mexico and possibly others, implying prolonged uncertainty on this front. Next to the direct effects of tariffs, indirect effects (on business confidence, financial conditions and investment) are likely to be large. We have cut our growth forecasts for key economies (US, Eurozone, China/EM Asia and assume that central banks and governments will react globally with an easing cycle starting before the end of the year. We expect the Fed to cut its policy rate (three times, each by 25bp in the coming three quarters), the ECB to relaunch QE and the Chinese authorities to step up stimulus (see for more detail here).
Mixed impact on EM capital flows
Ceteris paribus, continued escalation of trade, tech and other tensions between the US and its major trading partners is a negative for risk sentiment and hence a potential risk for future portfolio flows to emerging markets. At the other hand, should the Fed indeed react by cutting policy rates again (as we assume), that would be a supportive factor for portfolio flows to EMs. To put it shortly: one headwind has intensified, (trade tensions), but Fed and other central bank easing should form a tailwind.
In addition, we do not expect a collapse in commodity prices. Furthermore, past EM FX depreciations have, together with policy measures and in some cases lower growth, already contributed to external adjustment helping to keep external deficits under control (for instance in Argentina and Turkey, countries that were hit most last year). All in all, we have lowered our growth forecasts for a couple of emerging markets (e.g. China, India, other EM Asia, Brazil, Mexico, South Africa), but at this juncture still do not expect widespread recessions and/or broad balance of payment problems in EMs.