Structural upside remains, despite tightening conditions

In a nutshell

• Investor flight from emerging markets is inflicting damage to their financial markets and currencies – even though underlying fundamentals remain broadly supportive.
• With emerging central banks forced to take a tighter stance, the risk is that economic growth be hindered during coming months, albeit not to the point of falling into recession.
• A selective approach remains warranted, but structural upside remains.

Emerging markets are enduring their most challenging year since the 2014-2015 commodity collapse, amid rising US rates, a stronger dollar, mounting trade tensions and a slew of domestic political risks.

Of our 18-country universe, all currencies except the Columbian peso, Mexican peso and Thai baht are down year-to-date versus the greenback, with moves ranging from over -50% for the Argentinian peso, -40% for the Turkish lira and -20% for the Brazilian real to just -2% for the Malaysian ringgit or the Peruvian sol¹. Against the dollar, all the currencies we monitor now look cheap, Thai baht and South Korean won excepted.
 

Is this a fair representation of domestic economic realities?

We don’t believe so. The risk is, however, that a prolonged period of currency-induced tight financial conditions starts to affect otherwise broadly sound fundamentals – indeed much improved in recent years.

Current account deficits have for instance narrowed meaningfully, with only five countries still below the -2% mark (see chart X). The countries under most pressure are precisely those with the weakest external position: Turkey and Argentina. On that count, we should carefully monitor South Africa and Indonesia, while Colombia does display a relatively large deficit but with an improving dynamic. External reserves have also grown markedly, now above 20% of GDP on average. Here again Turkey, Argentina, Indonesia and South Africa look weakest.

Finally, the still young recovery means that central banks started 2018 with near all-time low interest rates. As we expected, they have begun to use this leeway to support their currencies, with Mexico, Argentina, Indonesia, India, the Philippines, Turkey and Russia having already raised rates. Outside of the two extreme cases of Turkey and Argentina, monetary policies can now be deemed broadly neutral (see chart XI). Monetary tightening will be another headwind to future growth, but not enough to cause a  recession.

Overall, economic fundamentals indicate that most emerging markets can still deliver structurally, but tighter US dollar funding, trade tensions and rising rates will weigh on growth in coming months, warranting a selective approach.

¹ As of 28 September 2018, close of business