Cyclical tailwinds are fading, but the structural case still looks valid

In a nutshell

• The period of easier monetary policies across the emerging world is coming to an end.
• Structurally, though, the case for emerging markets remains valid: imbalances have moderated, foreign currency debt has diminished, and international reserves have swelled.
• Selectivity is nonetheless warranted, with the most robust economic fundamentals to be found in Asia, but also Russia, Chile and Peru.

Our shift, early in 2016, to a positive stance on emerging markets was based on cyclical considerations. Commodity prices were beginning to recover after their massive fallout, amid subsiding fears of a Chinese hard landing. With the US dollar to eventually peak at the end of 2016, the stage was set for a virtuous cycle of stabilising currencies, falling inflation and easier monetary policies.

Two years down the road, these cyclical tailwinds are fading. Monetary policies are likely to tighten somewhat (see chart IX,page 8) – although not to the point of derailing the upturn, which remains young.

Meanwhile, the structural case for emerging markets is still valid. From a peak of over 6% just before the financial crisis, the growth differential between emerging and developed economies has fallen back to 2.4%, slightly above its historical average. In turn, the current account surplus accumulated by the emerging world has all but disappeared. Foreign currency debt has retreated, and the stockpile of international reserves accumulated by emerging markets at large – not only China – since the turn of the century greatly reduces their vulnerability to external shocks.

That said, we recognize that tail risks stemming from protectionism are growing. US-imposed tariffs on China could have knock-on effects on countries with closely integrated supply chains, notably Taiwan or Malaysia. Were US protectionist inclinations to broaden beyond China, the disruption could be greater even – with many Asian countries, but also Mexico, Chile or Colombia, exhibiting significant domestic value-added in US imports.

For now, though, Asian countries dominate our ranking. China is slowing with medium-terms risks linked to its debt profile but remains solid at this stage, while India presents an interesting long-term growth story thanks to its young population. Outside of Asia, Russia, Peru and Chile stand out with supportive fundamentals. Brazil's destiny hinges on its ability to reform the pension system, and Mexico's on NAFTA (North American Free Trade Agreement) renegotiations and the July presidential election. Lastly, we remain worried about Turkey given its weak fundamentals and large imbalances.