To some, it’s a sucker’s rally – sustained by a “herd of dumb money.” Record wads of cash streaming into emerging and frontier markets have been sending stocks and bonds soaring. So what’s everyone worried about? Lisa Lewin, emerging markets economist for BMI Research, identifies 10 key risks and how to navigate them
1. The Fed, of course
Will investors dump emerging markets as soon as the Federal Reserve hikes interest rates? It all depends on the pace of hikes and the factors underpinning the moves. If the Fed signals a more aggressive tightening cycle than is currently being priced in, this would almost certainly prompt an exodus from emerging market assets. The dollar would surge, causing EM currencies to collapse on the flipside. The most vulnerable markets in this scenario would be those that are liquid and high yielding with shaky macroeconomic fundamentals, such as Brazil, South Africa and Turkey.
This isn’t the scenario we expect, however. We’re looking at the Fed Funds rate staying on hold through 2016, then rising by just 25 basis points in 2017 and 50 basis points in 2018. The gradual improvement in the US economy implied by this interest rate trajectory would be supportive of global growth and therefore emerging market fundamentals. Emerging markets would retain their appeal for several quarters, thanks to a strong differential in yields.
2. The trouble with Trump
Donald Trump has signaled that he’d reduce US military support for NATO states, as well as Japan, South Korea and Saudi Arabia. This might embolden Russia and China to expand their influence in the belief that Washington is no longer seeking to contain them. Relations with Russia would probably improve as a result of Trump’s reduced support for NATO and possible indifference toward Moscow’s controversial actions in the former Soviet Union. As for China, however, the relationship could become tense over an increasingly protectionist US stance on trade.
We assign around a 35% probability to a Trump presidency. If he wins, he might well tone down his rhetoric after coming to power.
3. Where Brexit breaks it
The biggest threat stemming from Brexit is the tail risk for the Eurozone: the bloc faces heightened risk of political, financial market, and economic contagion. From a trade perspective, Central and Eastern Europe is particularly exposed, while Asia has relatively low exposure.
Again, Russia is a winner from Brexit. With the EU in a state of confusion and paralysis, some governments may choose to pursue national as opposed to ‘pan-European’ interests and find cause to sympathize with Russia. Other emerging markets may also benefit: forthcoming UK trade negotiations provide an opportunity for developing countries to strengthen bilateral agreements as Britain pivots toward fast-growing economies.
4. In China’s shadow
China’s pressures include sluggish export growth, weak private investment, and capital outflows encouraged by falling real interest rates. As a result, the People’s Bank of China will favor incremental depreciation of the yuan and continue intervening in the markets in order to achieve this. We forecast that the yuan will weaken gradually to 6.8 to the dollar by year-end and 7.1 by the end of next year.
There’s also the risk, however, of a one-off devaluation. This could be triggered in the event of a domestic liquidity or banking crisis. Significant losses within China’s shadow banking system could necessitate a government bailout.
5. Further BRIC erosion
Both Brazil and Russia show signs of having passed the worst of their economic downturns, aided by recovering commodity prices and more stable currencies. Yet real GDP growth will probably remain below 2% a year through 2020. Brazil’s consumer sector will be sluggish amid elevated household debt and a weak labor market. Infrastructure bottlenecks will stymie economic activity and high tax rates will discourage investment.
In Russia’s case, the biggest drag on growth will be a lack of private sector participation due to the state’s tight grip on key sectors of the economy. Growth is also weighed down by commodity dependence, a rapidly ageing population and prolonged slump in investment.
6. Poland’s populists
Policies like new child benefits and the reversal of a previous increase in the retirement age will stoke inflation and push up public debt. The growing burden and widening fiscal deficit place Poland on a collision course with the European Commission over violations of the EU’s Growth and Stability Pact, and sanctions could result.
Still, we don’t view the expansionary fiscal policy as a pressing threat to sovereign creditworthiness. Total public debt is just above 50% of GDP and most of the debt is denominated in zloty, minimizing exchange rate risk.
7. Turkey’s precarious perch
Turkish reliance on ‘hot money’ flows to fund the current account deficit leaves the economy extremely vulnerable to capital flight. Heightened political risk in the aftermath of the mid-July attempted coup has increased the probability of a ‘sudden stop’. In a downside scenario, capital floods out of the country, the lira collapses as a result, inflation soars, the central bank hikes interest rates aggressively in a bid to stabilize the currency, and economic activity subsequently grinds to a halt.
Such a scenario could be triggered by a shift in global financial markets, for example if the Fed raises interest rates unexpectedly, thereby reducing the relative appeal of high-yielding emerging markets. But Turkey could also trigger a investor flight itself by exacerbating domestic political risk. President Recep Tayyip Erdogan is tightening his grip on power following the attempted coup, raising the risk of a backlash. The warming of relations with Russia could also alienate Turkey from the West.
8. Africa’s New Normal
Sub-Saharan African economies will generally struggle over the coming years owing to a combination of a slowdown in China; subdued (albeit rising) commodity prices; weak global demand; and in some cases, a high debt burden stemming from past fiscal excesses. We don’t expect the region’s two largest economies – Nigeria and South Africa – to bounce back to the growth levels seen prior to the global financial crisis at any point over the next ten years. Both will suffer from weak investment stemming from a lack of structural economic reform over recent years.
There are some bright spots. Ethiopia will outperform, posting average annual real GDP growth of 7.3% over 2016-2020, largely thanks to state-led investment into sectors including infrastructure, agriculture and manufacturing. Côte d’Ivoire will also be a regional outperformer, recording annual average real GDP growth of 8.2% over 2016-2020, owing to strong public investment and a private sector encouraged by ongoing pro- business reforms.
9. Rand caution
The rand has performed well this year as yield-seeking foreign investors flood back. However, the economy is close to recession and the poor showing by the ruling African National Congress in the August local elections poses substantially increased risks to policymaking, limiting the scope for crucial economic reforms. We hold a cautious stance on the rand, with our year-end target of 15 to the dollar implying 9.9% depreciation from spot.
We are cognizant of the upside risks to our view under three main scenarios. Firstly, the anti-Zuma wing of the ANC could gain ground, removing the president from office and opening the door for the implementation of a more rapid reform agenda. Secondly, interest rates could be tightened amid a hawkish shift at the central bank, bolstering real interest rates. Thirdly, global risk appetite for emerging market assets could surge from already elevated levels, with high-yielding currencies such as the rand particularly benefiting.
10. Naira Pressure
The naira’s peg to the dollar at an overvalued rate has stifled economic activity. Importers were unable to access adequate dollars, and foreign investors stayed on the sidelines owing to exchange rate uncertainty. The relaxation of the exchange rate policy on June 20 was an encouraging step forward for Nigeria. Although the central bank kept intervening in the month following the introduction of the new policy, it has now let the naira become more of a genuine free-float.
We expect the naira to fall further over the coming months, however, because the pent-up demand for dollars in the economy has not yet been cleared. The disparity between the current official exchange rate and that of the parallel market is evidence that liquidity remains an issue. Toward year-end, we expect that the naira will start to recover as foreign inflows pick up on the back of rising oil prices and reduced exchange rate uncertainty.
Where are the best places to invest in emerging and frontier markets? Hear BMI Research’s top 10 picks with emerging markets economist Lisa Lewin on the Emerging Opportunities show: