Follow the fundamentals
20 February 2018
As the dust settles on the recent sell-off and bout of market volatility, the impact on emerging market (EM) economies appears to be limited. After all, there wasn’t anything EM-specific about the recent market downturn. The MSCI EM Index moved roughly in line with MSCI World Index, both on the upside in 2017 and as markets moved down earlier this month (see Chart 10). Outflows were primarily out of equities, while EM bonds still saw non-resident inflows, and the currency moves contained few surprises. Manufacturing exporters in Asia and Europe-oriented EMs performed best, while commodity currencies and countries with external deficits were the worst performers (see Chart 11). While EM fundamentals still appear healthy, the question is whether the tail risks that partially lay behind the turbulence of the last two weeks could move beyond market impact and begin to impact fundamentals and undermine the EM recovery?
In last week’s briefing, we highlighted the factors that impact capital flows to EMs, namely the dollar and EM growth outperformance. In this week’s briefing, we focus on the outlook for these variables in an attempt to gauge how EM could be impacted. As highlighted last week, the dollar is a significant factor in the EM outlook, not just for EM FX performance, but more broadly for capital flows and EM financial conditions. Unfortunately, the outlook is also highly uncertain. The budget approved last week in the US looks set to considerably widen the fiscal and current account deficits. This late-cycle stimulus is likely to lead to faster monetary policy tightening. However, uncertainty remains about the seeming contradiction between rising rate expectations and the softer dollar. Higher rates may eventually support a dollar recovery; or this cycle could resemble the 2004-2006 cycle when rates moved higher but EM FX were resilient against the dollar. How these forces ultimately play out will have significant implications for EMs. Despite the many uncertainties, following the initial increase in outflows that began on January 30th ($7.5bn for equities and $1.8bn for bonds to-date), outflows look to be subsiding according to the most recent IIF data. Furthermore, a broader question remains as to whether EMs are becoming more resilient to reversals in foreign flows -- rising wealth in EMs and increased intra-EM investment could make them less reliant on developed market (DM) flows.
The growth outlook remains largely unchanged. The balancing forces of improving DM demand and weakening Chinese demand will continue to impact the EM outlook. The biggest outstanding question is the outlook for EM ex-China domestic demand. As China slows, the two key drivers of EM's growth rebound over the past two years – accelerating global trade volumes and improving terms of trade for EM commodity (and microchip) producers – are less likely to continue over the medium term. EM growth in such an environment will depend increasingly on the trajectory of DM demand, but also on EM ex-China domestic demand. While DM growth appeared to remain strong through the end of last year, EM domestic demand has lagged. EM data, especially PMI and IP data, have not shown the strength seen elsewhere in DM. However, this may be changing as EM credit growth appears to have troughed amid signs of improving investment.