Emerging Markets Quarterly Outlook

2018: Another Year of MOTS and FOMO?

The past year was a stellar one for emerging market (EM) equities: the MSCI EM gained a full 37% in USD terms in 2017, its best performance since 2009. In retrospect, it is not difficult to understand why. While global politics were fraught with surprises, tensions and volatility, the economic stars aligned almost perfectly: the global economy operated above potential (with a leadership rotation from the US towards Europe and Japan), world trade continued to rise, inflation remained moderate, earnings growth was robust around the world and monetary policy of the leading central banks remained broadly accommodative.

Markets enter the new year facing a series of challenges. Nevertheless, the consensus is for More Of The Same (MOTS). To some extent this will likely hold: for example, the IMF expects global growth to rise from an estimated 3.6% in 2017 to 3.7% in 2018, (from 3.2% in 2016). Even if growth disappoints and does not accelerate, it will likely remain above trend. For financial market participants this could further stoke their Fear Of Missing Out (FOMO). In 2017, portfolio inflows into EM rebounded and were on track for a net $285 bn, double the total of the previous two years. At the same time, market and liquidity risks have become elevated and medium term vulnerabilities have risen. Several factors suggest caution in chasing returns: 1) the outlook for US and developed market (DM) policy, 2) recent financial market behaviour and 3) local EM election risk.

1. US/DM Policy

The monetary reversal in DM has now begun in earnest, with central banks either tapering asset purchases, reducing asset holdings and/or hiking rates. The US yield curve has flattened, possibly presaging recession, though a bigger concern is a potential rise in long term rates or an upward shift of the curve. Implementation of the US tax reform could produce a one-off boost to US growth of 0.3% points according to estimates. There is a legitimate debate about the stage and the longevity of the US business cycle and whether with growth at 3.2% saar in Q3 and unemployment at 4.1% such fiscal stimulus risks overheating the economy. This might spark inflation and prompt the Federal Reserve into rash rate hikes. As it stands, markets expect the economy to accelerate from 2.3% growth to 2.6% in 2018, the US Core PCE to rise from the current 1.5% yoy closer to 2% in 2018, and the Fed to raise rates by 50-75bps. The Fed’s balance sheet is expected to shrink by approximately $415 bn in 2018, but the ECB’s and the BoJ’s asset purchases will more than compensate for this. Here too is a risk though as the ECB will seek to extricate itself from continued asset purchases as the Eurozone economy powers ahead.

But while the US tax package is unlikely to significantly boost demand or ignite wage pressures, the likelihood of rising long term rates in the face of a large unfunded fiscal widening and simultaneous Fed asset sales is material. This could be unwelcome for the US economy as well as for emerging markets with large funding needs. What is more, any accompanying US dollar strengthening would weigh on EM dollar returns. All told, monetary conditions will remain broadly supportive for the global economy but less so than in 2017 and with a considerable risk for a sharp tightening.

2. Volatility & Leverage

Volatility has remained surprisingly subdued in 2017 despite the various risks that emerged throughout the year, be they electoral surprises in Europe, natural disasters in the US, the ructions in the Trump White House or the escalating war of words with North Korea. It is true that geopolitical events are rarely anticipated by financial market pricing. But financial markets (VIX readings) also failed to anticipate the Great Financial Crisis in 2007 and dwelled instead on the “Great Moderation”.

But the issue is that low volatility bestows a false sense of security. In fact, a prolonged spell of low volatility can ultimately make the financial system more vulnerable to crisis, a phenomenon known as the “volatility paradox”. In a benign risk environment, when monetary policy is super-accommodative, investors are pushed into highly levered, ever riskier asset classes (outside their natural habitat), which mostly benefit the least creditworthy. Low realised volatility in turn encourages financial market participants to increase their positions as their risk management strategies suggest ever lower value-at-risk. And indeed, leverage is currently higher than before the crisis: global debt increased by $60 trn since 2006. External borrowing has sharply increased in emerging markets in general and in China’s shadow banking system in particular.

While the financial system may today be stronger as systemically important banks and insurers have become more resilient thanks to increased capital and liquidity, investors may struggle to exit crowded trades once volatility increases. This could be set off by policy changes such as rising rates, inflation or growth shocks, a high-profile default, a breakdown in trade relations or any geopolitical flare-up.

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