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Emerging Markets Monthly Summary - 9 November 2017

Core Content

This report provides an overview of the state of emerging markets (EM) and the global economy, focusing on economic forecasts, policy outlooks, and investment strategies. It highlights the mixed performance of EM economies, the cautious stance of policymakers, and the implications of global monetary conditions on EM assets.

Main Points

• Overall Outlook: The report maintains a "half-empty" view of EM, but remains constructive about the broader emerging economies. EM GDP growth has been strong, while inflation remains subdued, limiting downside risks.
• Global Growth: Global real GDP growth is expected to rise to 3.7% in 2018, with the US leading the way at 2.4%, and EM growth projected at 4.8%, up from 4.2% in 2017.
• Inflation Trends: Inflation remains largely in-check across EM, with the notable exception of Turkey, where it hit a nine-year high of 11.9% YoY in October. EM central banks have room to gradually tighten policy, especially in countries with higher leverage.
• Policy Environment: EM central banks are expected to maintain accommodative policies, with some exceptions, such as Russia and Turkey. The report notes the challenge for policymakers in balancing economic growth with inflation control.
• FX Volatility: EM currencies are becoming more sensitive to US yields. While local market outflows are easing, EM FX is expected to remain under pressure due to uncertainty around US tax policy and liquidity conditions.
• Credit Market Outlook: EM credit is expected to be more resilient than local markets. The report suggests overweighting Argentina, Ecuador, Malaysia, and Mongolia, while underweighting Poland, Hungary, and Sri Lanka.
• Event Risks: Event risks are highest in Venezuela, where the government is considering restructuring. Mexico, South Africa, Turkey, Colombia, and Brazil also face political uncertainties.

Key Economic Forecasts

Special Reports

• LatAm Corporates: More cautious on Mexico energy due to election-related volatility, while Argentina's energy liberalization offers stability for integrated energy firms.
• EM Local Rates: The monetary policy premium is the main source of value in the long end of EM. The valuation buffer is sufficient to shield some EM markets from a Fed balance sheet unwind.
• Asia Vulnerability Monitor: Some EM Asian markets, particularly China and Hong Kong, are seen as overstretched due to rapid debt growth, with Hong Kong's property market facing the highest downside risk.
• China's LGFV Debt: Financial conditions for local government financing vehicles (LGFVs) have worsened, with infrastructure investment growth expected to slow in H1 2018.
• Indian PSU Bank Recapitalization: The Government of India announced a $30 billion capital injection into public sector banks, which should help resolve capital adequacy concerns and impact fiscal deficit, debt, growth, monetary policy, and ratings outlook.

Investment Strategy

• FX Strategy: Favor North Asia over South Asia. In South Asia, prefer THB and MYR. Hold steepeners in India and Korea, while selling PDVSA 20s and CNH CCS flatteners.
• Credit Strategy: Overweight Argentina, Ecuador, Malaysia, and Mongolia; underweight Poland, Hungary, and Sri Lanka. Favor cash curve flatteners and long CDS/bond basis in select names.
• Entry Opportunities: Enter Egypt 47s vs. 28s, Brazil 26s vs. 5Y CDS, Turkey 26s vs. 5Y CDS, and Colombia 27s vs. 10Y CDS.
• Market Positioning: Expect continued unwinding of long EM positions due to UST supply uncertainty and market pricing not yet aligned with FOMC dots. Local markets are expected to bear the brunt of FX volatility, while hard currency debt remains more resilient.

Risks and Outlook

• Event Risks: Highest in Venezuela, with potential restructuring and default risks. Mexico and South Africa also face political risks.
• US Policy Impact: US tax reform is a key risk for EM, with potential impacts on US yields and the USD. A diluted version of the bill is expected to have a moderate effect on EM.
• Inflation Concerns: While inflation remains subdued, there are concerns about oil prices and their potential impact on inflation expectations. Countries with poorly anchored inflation expectations may see more rate hikes.
• ECB/BoJ QE: The ECB and BoJ QE spillover effects are expected to cap the repricing of risk in EM, especially as the global business cycle approaches its peak.

Conclusion

EM remains a mixed bag, with strong growth but cautious outlook due to inflation control and FX volatility. The report suggests a balanced approach, with a focus on protecting gains and being selective in market positioning. While the Fed's policy is expected to remain accommodative, EM central banks will gradually tighten to manage inflation and leverage. Political risks and event risks, especially in Venezuela and Latin America, continue to be a concern, but EM credit is expected to be more resilient than local markets.