Emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Emerging market (EM) equities and bonds continue to perform well, benefiting from the global search for yield and the tentative improvements in EM fundamentals. With regard to fundamentals, it is important to note that the better overall EM capital flow picture and the pick-up in EM growth momentum are largely linked to the benign global liquidity environment of the past quarters. But regardless of the exact explanation, the general state of the emerging world is much better now than it was in the last few years and the beginning of this year.
Emerging markets have to deal with several headwinds
Currently, there is no situation of critical capital outflows that can easily make policy makers panic, EM growth has been picking up somewhat since June and EM exchange rates have adjusted to a more realistic level. This partly explains why EM assets have not been affected by a number of issues that not so long ago could easily have caused investors to take their money elsewhere. First, there is the sharp decline in the oil price since June. Second, the market started to re-price Fed rate hike expectations following the strong US labour market report of July. And third, most recent Chinese economic data were far from convincing. In other words, emerging markets are better positioned now to deal with headwinds, which only a few quarters ago caused serious financial market turmoil.
Of course, recent moves by the Bank of England and expectations about the Bank of Japan and the European Central Bank have kept investors confident that easy monetary policy in developed markets will continue for longer. In this environment, some adverse data and news flow are considered manageable. At any case, investors are not intending to throw in the towel on the EM yield theme yet.
Lower oil price not seen as evidence of EM demand problem
What is particularly remarkable is that the sharp decline in the oil price of the last two months has not affected emerging bond and equity markets. Oil-sensitive markets such as Russia and Colombia have underperformed, but emerging markets as a whole have not suffered. This is in sharp contrast with the second half of last year, when the falling oil price created a lot of additional nervousness about the overall EM growth picture and the external and fiscal vulnerabilities of the commodity-exporting economies.
The main explanation of the different market interpretation of the lower oil price lies in the better EM growth picture. Growth momentum is clearly improving throughout the emerging world. This makes it easier to believe that, this time, oil is declining primarily because of oversupply concerns and not because of a worsening EM demand outlook.
No significant impact from repricing of Fed expectations
In our base-case scenario, the Federal Reserve will hike interest rates in December. A December hike was completely priced out a month ago. Now, the probability is almost 50% again. The re-pricing of a Fed rate hike this year has not affected emerging asset markets and we feel that a further re-pricing of a December hike should not be a big problem either. The main reasons are the better EM growth backdrop and reduced external financing requirements in most emerging economies. A crucially important condition for a limited market impact of the re-pricing of Fed tightening is that the market continues to believe that the normalization of US interest rates will remain a very slow process.
Current pace of China slowdown appears manageable
At this stage, we are more concerned about the recent deterioration of Chinese economic data. We still think that the Chinese economy is generating reasonable numbers, but doubts about the growth stabilisation have emerged again. Real estate sales growth seems to have peaked, while private investment growth continues to struggle. The capital flow picture remains a big positive change compared with last year and the beginning of this year. The authorities have been successful in stabilizing flows, which suggests that policy makers are in control again.
We are keeping our view that Chinese growth is in a multi-year slowdown. A sharp deceleration with increasing system pressures was what we feared last year. Recent data still give enough comfort that the current pace of slowdown is manageable. But at the same time, we continue to think that a deterioration in Chinese growth is the single-most important risk to all EM assets. So if we talk about the recent resilience of emerging market assets, we feel that the most remarkable has been that investors have shrugged off the disappointing Chinese data.
EM central banks will continue to ease monetary policy
As long as the global liquidity environment remains benign and inflation in the emerging world continues to decline, central banks in emerging countries will continue to loosen their monetary policy. Our monetary policy stance indicator has been in positive territory since March and has sharply risen since May. It tells us that more monetary easing has been taking place recently. For emerging debt markets this is hugely important. Not only because declining yields push the value of the bonds higher, but also because more easing of financial conditions should help the EM growth recovery to broaden out and strengthen.
Jacco de Winter is Senior Financial Editor at NN Investment Partners.
