19 July 2018
June appears to have been a tentatively better month for emerging markets (EM) on aggregate. The ‘EM ex China’ Purchasing Managers’ Index (PMI) edged up for the first time this year. Data out of China is mixed and still suggests a softening trend, but was more encouraging at the margin.
Source: Fidelity calculations, National Sources; Haver Analytics
Nonetheless, one month does not make a trend. With our Fidelity Leading Indicator (FLI) stuck deeply in the negative, especially in key EM-sensitive areas like global trade and commodities, the outlook is subdued. Moreover, the most vulnerable EMs - Brazil, Turkey, South Africa - have seen their PMIs plummet further, back in contraction.
One important development is that broad EM currencies have tentatively stabilised in recent weeks, although several Asian currencies have come under pressure since mid-June as the renminbi ‘anchor’ gave way following PBoC easing. While this is marginally positive for EM countries’ inflation-policy-growth mix, forceful US Fed tightening and worsening global growth conditions will keep emerging market currencies and central banks on the back foot. Indeed, to see significant respite for EM financial conditions, investors may need to wait for the Fed to show signs of relenting on its current policy of steady rate hikes and ‘quantitative tightening’. Such an easing off may be forthcoming later in the year, but for now it is not on the table.
China eased policy at the margin in late June, cutting the Reserve Requirement Ratio (RRR) for banks to unleash ~0.7 per cent of GDP liquidity (although of course, China’s debt load is over 250 per cent of GDP). This led to a sizeable drop in domestic interest rates, which in turn caused a renminbi depreciation that was ultimately well-controlled. Capital controls and intervention by state owned banks seemingly remain an effective backstop.
Source: Tullett Prebon Information, National Interbank Funding Center, Bloomberg, Haver Analytics
While further such RRR cuts are perfectly likely, Chinese domestic conditions will remain relatively tight; broad credit expansion continues to run at the slowest rate since the tough times of mid-2014 to mid-2015. This will keep growth under pressure - reflected in cratering industrial metals prices and weaker data - although a continuation of the current, manageable slowdown is the base case. The possibility of a ‘policy mistake’, e.g. leading to painful credit defaults, is always a key ‘tail risk’.
Despite countless headlines dedicated to US-China trade wars, pinning them as the root of all sell-offs, the economic magnitudes are small and risks overblown. Estimates of the impact of Trump’s mooted tariffs on $250bn of goods (plus retaliation) on Chinese GDP come in below 0.5 per cent; the dollar amount of the measures themselves are just 0.23 per cent of GDP (and so far, we’ve only seen tariffs actually implemented on $34bn of goods). Put another way, a flat 10 per cent US tariff on all Chinese goods is equivalent to a 10 per cent stronger renminbi vs. the USD. Of course, we have already seen a 6.5 per cent fall in renminbi-USD, sufficient to offset most of the pain from tariffs that have not even happened. That said, tensions will remain and continue to create uncertainty, not least because Donald Trump knows that hawkish rhetoric (not actual actions) wins votes.
To conclude, EMs will remain under pressure in the coming months, with the key drivers being tougher US-driven financial conditions (rate hikes and quantitative tightening, combined with the ‘crowding out’ of growing budget deficits) and slowing China growth due to its significantly negative credit and fiscal impulse. The 2016/7 experience of a virtuous cycle of strengthening EM currencies, lower inflation, easing EM central banks, and stronger growth has screeched into reverse. That said, risks from a trade war or disorderly renminbi sell-off are of minor importance for now.
Until global growth perks up, as measured by the FLI or catalysed by Chinese easing, or the Fed relents on policy tightening, we remain cautious on broad EM risk. This said, following the latest sell-off, EMs may be better ‘priced’ for global risks than many developed market assets, and there are some attractive idiosyncratic/‘higher quality EM’ opportunities.
- Despite a tentatively better month in June for EM activity and currencies, emerging markets are not out of the woods.
- The Fed is still not relenting on its hiking trajectory, and may still underestimate - or not be too bothered by - the combined impact of quantitative tightening and rising US treasury issuance, most notably on EMs.
- China’s slowdown on anaemic credit growth is becoming increasingly visible. Will the PBoC’s nascent shift away from the policy brakes put a halt to this - or does that just tell us that the slowdown is becoming significant?
- Until these main factors start to reverse, EM’s self-reinforcing ‘FX-inflation-policy-growth’ cycle could stay stuck in decline.
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