Emerging Market Risks Unrelenting Until End-Decade Rebound
After more than 25 years providing independent analytical research and advisory services to public and private sector clients on developed and emerging economies through numerous economic and financial market crises, Kleiman International is for the first time publicly offering its views for 2016 in this summary previously reserved for clients. This brief analysis will offer the firm’s review of last year and opinions of the risks and vulnerabilities, and potential opportunities, facing emerging economies’ currencies and financial markets incorporating the broader global picture.
Last year’s dismal emerging market stock performance is expected to be repeated after the MSCI Emerging Market and Frontier stock indices fell more than 15 percent – with gains recorded in only Hungary in the former and Estonia, Lebanon and Jamaica in the latter – although externally issued sovereign bonds, as measured by JP Morgan’s EMBI measure, ended up 2 percent on double-digit advances by Ukraine, Argentina, Venezuela, and Russia. Similarly, currency depreciation – which resulted in declines of more than 20 percent against the US dollar in Brazil, South Africa, Colombia, Turkey and Russia in the major emerging markets – is expected to continue on the China slowdown, low commodity prices, and depressed global trade.
The US Federal Reserve is expected to tighten gradually while Europe, Japan, and China loosen monetary policy to spur growth and inflation. Geo-political risks – and the accompanying economic fallout – will remain elevated while commodity prices continue soft and global trade continues to deteriorate. Rising concern over excessive leverage in emerging economies – largely private as opposed to sovereign, which triggered past crises – will continue to weigh on investor sentiment even if battered currencies begin to recover against the US dollar as an estimated 90 percent of debt is domestic.
In the core emerging markets, vulnerabilities are evident across the universe but differ by country and risk factor. Over the past two decades, a US Federal Reserve rate hike has immediately resulted in virtually a wholesale flight to safety. We would argue that this time is different as anticipation of tightening grew steadily beginning with the 2013 “taper tantrum” which sent investors fleeing risky assets. Throughout the same period many of the largest core markets have slowed sharply, triggered either by global issues like commodity price falls, the slowdown in China, and geo-politics, or by domestic economic and/or political issues. The BRICS economies will remain particularly in the spotlight in 2016, as evidenced by the China-induced volatility in the first week of trading this year.
The economic slowdown and currency uncertainty in China, despite inclusion of the yuan in the IMF’s SDR, is expected to continue to deepen in 2016 as investors and the State Council try to gauge the extent of the slowdown amidst economic rebalancing and soaring debt levels. The December launch of a new trade-weighted RMB exchange rate index heightened expectations for currency depreciation, with a drop of 10-15 percent against the US dollar likely by year-end. At the same time, regulatory shifts on stocks, bonds and the currency are likely to continue apace – as well as reverberations from the anti-graft campaign – which will continue to weigh on investor sentiment as predictability is a key ingredient for foreign investor decision-making. Interest rates are likely to be cut significantly to prop up the economy as fiscal spending continues to accelerate after surging nearly 26 percent on an annual basis in November. Financial market volatility and a growing number of on- and off-shore corporate bond defaults will also undermine overseas investor sentiment. Real GDP growth data will come under heightened scrutiny, particularly after the state-run media reported that several regions inflated economic indicators reported to the central government by at least 20 percent.
Elsewhere in emerging Asia, attention will focus on falling exports, slowing growth, and elevated levels of corporate and household debt. Oil-exporter Malaysia, where the ringgit lost 19 percent last year and was the worst performing currency in the region as the stock market fell by 22 percent in dollar terms on the MSCI Index[1] , will remain under pressure despite evidence that the heavily indebted state investment company 1MDB is reducing its leverage from asset sales. Commodity prices will continue to weigh as the budget deficit will remain stubbornly above 3 percent of GDP despite the widely hailed launched of a goods and services tax, while political risk will similarly continue to dent investor confidence with the ongoing investigations over graft against the Prime Minister. Next door in Indonesia, commodity prices will continue to weigh on the world’s biggest palm oil grower and thermal coal exporter after the stock exchange lost 20 percent in 2015 and the rupiah was down 10.9 percent against the greenback. Both markets are at risk of further currency pressure due to heavy foreign holdings of local government bonds. Thailand, where the stock market lost a quarter of its value while the currency was down 8.5 percent, is likely to outperform neighbors as a stimulus program, rural debt relief, and USD 50 billion multi-year infrastructure plan offset concern about falling trade, high household debt and the delay of constitutional reform and return of civilian rule.
In South Asia, the Indian economy expanded 7.4 percent on an annual basis in the third quarter after growing 7.0 percent three months earlier. The Paris-based OECD is projecting that India will have “one of the highest levels of growth” among emerging Asian economies this year, and projects economic expansion of 7.3 percent boosted by consumption and investment. Inflation continues to tick up on food prices, which account for almost half of the CPI basket, after a poor monsoon season. Investors have welcomed liberalization under the Modi government but worry that key reforms, including tax rationalization and legislation on labor and land reform, will stall in parliament. The commodity price crash has resulted in a narrowing of the current account deficit which is expected to remain steady in 2016, as the currency holds up better than ASEAN neighbors – it fell only 4.9 percent against the dollar in 2015 – while the stock market loss of just over 7 percent was the least in the core Asian emerging market universe. Nearby frontier stock markets Bangladesh, Pakistan and Sri Lanka turned in losses averaging 20 percent. In Pakistan continued IMF program observance is expected to result in economic expansion in the 4 percent range, although both the country and neighboring Sri Lanka are expected to see yields on their recently issued global bonds tick up on the global sell-off and strong dollar.
In Latin America, attention will continue to focus on the continent’s biggest market in 2016 as Brazil continues to grapple political and economic chaos as it prepares to host the Olympics. The currency, off more than 30 percent against the US dollar last year, is expected to drop by a similar amount in 2016 as bond yields rise following the sovereign downgrade to junk status by two ratings agencies with the economy expected to contract more than 3 percent. Funding the twin fiscal and current account deficits is increasingly expected to be challenging as the economy remains in deep recession while politics surrounding the impeachment of the president and the Car Wash corruption scandal are likely to deter needed fiscal and structural reform. In next door Argentina however, investors welcome the rapid return to free markets under President Macri who in his first full week in office lifted capital controls culminating in a large scale currency devaluation. While talks with hold-out creditors and high inflation following the lifting of capital controls will be areas of concern, the medium-term outlook for the economy is, particularly in terms of trade and investment, the brightest since before the sovereign’s 2001 default.
Exporters Chile, Colombia, and Peru – where stock markets sank 18 percent, 43 percent, 32 percent, respectively, while their currencies plummeted in line with commodity prices – are expected to continue to turn in soft growth and higher inflation. Peru’s presidential election in April is likely to go to a second round two months later, while stalled reforms in Chile are unlikely to be resolved. Overall economic performance in all three markets will remain dependent on commodity prices, which could force fiscal overhauls on rising deficits. The December election in Venezuela resulted in a short-term bond rally after President Maduro’s party took only a minority of seats but the prospect for a default continues to rise on low reserves and oil prices.
To the north, Mexico – where the peso and stock market fell 15 percent, the least of the major Latin American markets – inflation is at a record low and the currency’s depreciation has spurred manufacturing which is expected to continue to grow as the US recovery continues. Authorities hedged the price of oil and the IMF estimates the move saved the country USD 6.4 billion last year as oil prices sank. Despite the global emerging market sell-off, international investors continued to buy peso bonds and foreign direct investment rose sharply. The 2016 outlook for Mexico is strong with the IMF predicting GDP growth of 2.5 percent even with higher interest rates on strong domestic consumption.
In Central Europe, Hungary outperformed last year with the stock market turning in the only positive performance in the core MSCI emerging market universe, with a strong 33 percent advance. Interest rates are at a record low, the current account is in surplus and onerous levies on largely foreign institutions are due to be cut. Despite years of unease over government policies targeting foreigners, the government’s unpopular tax take on banks and other sectors has righted finances and the debt level is decreasing. A return to investment grade is likely this year as the government pushes ahead with bank privatization. In contrast, the Warsaw Stock Exchange lost more than a quarter of its value and the currency fell sharply against the euro while benchmark local 10 year bond yields rose, with the heaviest losses following the election of the Law and Justice Party. The new government vows to seize more control over the economy and concern over policy was heightened by the removal of executives at state-run enterprises and a new law which brought state media under government control. To the East, the Russian stock market ended flat as the ruble lost 20 percent against the dollar on falling commodity prices, international sanctions, and a deepening recession which will extend at least through this year as inflation remains in double digits. Ukraine’s stock market was down 42 percent last year and the currency has depreciated 65 percent since the former President fled the country, sending inflation over 40 percent. While parliament adopted a 2016 budget, there is worry that the IMF will not approve it and release the much-needed delayed tranche of funding this month, after having received nearly USD 10 billion from the IMF and other lenders last year.
To the south, Greece, recently returned to emerging market status, turned in the worst core market performance, with the market down 62 percent following elections, capital controls, and a third bailout. While banks have been recapitalized again, capital controls remain in place and fear is growing that the government will be unable to complete its first review with lenders under its bailout agreement and/or the government will be unable to pass needed legislation with only a slim parliamentary majority. In next door Turkey, where the lira lost a quarter of its value against the dollar and the stock market was off by one-third, concern over geo-political risks is rising as the country grapples with the fall-out of the war in Syria and the end of a truce with Kurdish militants. Despite the political void in the run-up to the second parliamentary election last year, the budget and current account deficits narrowed but investors and ratings agencies will continue to focus on the country’s vulnerability to external risks due to its high reliance on foreign capital.
Finally, in the Middle East and Africa commodity producers saw stock, bond and currency market routs. In the Gulf region, stock markets sank 15-20 percent as Saudi Arabia posted a budget deficit of 15 percent of GDP spurring investors speculate that the Kingdom will be forced to break the currency peg as oil prices remain low. To the west, the Egyptian stock market lost a quarter of its value while the pound fell 9 percent pushing inflation up to near 10 percent. Foreign reserves remain low and the shortage of hard currency is likely to worsen as tourists stay away after the downing of the Russian jet worsened security concerns. Commodity producer South Africa saw its share market plunge by more than one-quarter as the rand plummeted 35 percent in 2015. The sovereign is likely to lose its investment grade status this year as the twin current account and fiscal deficits widen. Finally, the continent’s biggest economy, Nigeria, also saw nearly a quarter of its stock market value disappear while the currency dropped 10 percent even with heavy central bank support which wiped more than 15 percent off of reserves despite moves to limit the availability of hard currency to importers mid-year. In the frontier African markets, the numerous nations that have come to market with Eurobonds in recent years will continue to see yields spike and currencies drop, as Zambia, for example, saw its currency fall 42 percent in 2015 and inflation soar to over 20 percent as the copper producer suffered from the commodity price drop.
In developed markets, a series of potential risks in Europe could threaten this year. Alongside the Greek government’s potential loss of its slim parliamentary majority over pension and other reforms, which would threaten the bailout program and return the world’s attention to the crisis, Portugal could lose its last investment grade rating, making its sovereign bonds ineligible for ECB purchases, and Spain may have a prolonged policy void if it goes to another round of elections. At the same time, the refugee crisis may change the political landscape in Germany, where the previous euro-skeptic, turned anti-refugee AfD party continues to gain support ahead of 2017 federal elections, while the right-wing National Front in France continues to draw support.
In the emerging market universe, the vulnerabilities will continue to weigh throughout the year, driven by the China slowdown which will impact not only on neighboring markets but also commodity and goods exporters across the globe, including Germany, Brazil, and South Africa. Ten days into 2016 data out of most emerging markets is dismal: China’s FX reserves were down USD 512.66 bn in 2015 to USD 3.33 trillion with December recording the biggest monthly decline on record, Brazil reported 2015 annual inflation of 10.67 percent, the highest since 2002, Russian retail sales collapsed 13 percent in November, the biggest drop since 1999, etc. However, there are some brighter signs. India’s growth is expected to top 7 percent, the domestic-demand driven Philippine economy is among the most insulated in emerging Asia from China and is likely to grow more than 6 percent despite global turmoil and May elections, and Mexico’s recent reforms and a growing US economy are expected to continue to attract bond and foreign direct investors despite the low price of oil and equity sell-offs.
Another positive element this year is renewed emphasis on financial market development as part of bypassed post-2008 crisis structural reforms. In Europe, for example, Hungary and Turkey are overhauling stock exchanges, while cross-border integration such as the Andeans’ MILA should also further align regulation and trading. Official lender support could also be better positioned with the arrival of China’s Asian Infrastructure and the BRICS Bank, as the IMF after a 5-year delay got US Congressional approval for quota changes and permanent resource doubling to almost USD 1 trillion. These factors may help mitigate otherwise continued unfavorable GDP growth, earnings, commodities, fund flows, leverage, economic policy and geopolitical fundamentals, and individual asset classes could see modest gains. Equities could improve in a range from flat performance to low-single digit MSCI losses due to low valuations after three years of reversal; the EMBI sovereign reading should remain up on minimal activity while hard currency corporate debt finally corrects on a default wave; and local currency bonds could rebound selectively with less severe dollar appreciation. However 2016 results will still be mixed as a uniform rally awaits medium-term changes to economic, political and financial system models to reinvigorate investor confidence and enthusiasm, with end-decade marking the possible start of another lasting boom period.
[1] All stock market data is in US dollars on the MSCI Index as of 31 December 2015
