The growth of emerging markets (EMs) continues to gain pace, with an increasing number of EMs in a recovery mode. Manufacturing PMIs and industrial production growth have held up in most EMs, despite higher US interest rates. Import volumes, a proxy of domestic demand, have also picked up, while external demand is supported by decent DM growth, says Morgan Stanley in a research report.
A tight monetary policy stance, reflected in high levels of real interest rates, has helped to restore macro stability in EM countries which previously faced adverse highflation. At the same time, deflationary pressures declined in EM Asia on the back of stronger growth in China and a continued recovery in commodity prices. Higher real rate buffers and better external balances have helped EMs to withstand external risks well so far, it says, adding that they expect EM growth to accelerate to 4.7%Y and 5.0%Y, in 2017 and 2018, respectively, up from 4.2%Y in 2016.
However, there are three main risks in the current environment which Morgan Stanley believes could derail the EM recovery.
1) US Protectionism: The US is unlikely to adopt aggressive trade-restricting measures. However, the increase in US protectionist rhetoric has caused unease among investors given EMs’ relatively high exposure to trade. Mexico, China and Korea may be particularly negatively affected by an adverse change in US trade policy. Trade interconnectedness and global supply chains could amplify the negative impact of US protectionist measures in Asia.
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Note that under the scenario of a 20% tariff hike, the direct impact on GDP would be manageable for the majority of EMs (with the exception of Mexico) and potentially even be offset by a stronger US dollar. Indeed US imports are more sensitive to changes in relative income growth (US relative to the rest of the world) and relative supply conditions than to changes in import prices. However, the consequences of protectionist policies by the US could go beyond a simple price effect on US import demand. Any aggressive action against a major EM such as China would likely be met with a policy response. The perception of trade frictions between those major economies could increase global uncertainty and weigh on global trade and investment. Given EMs’ high exposure to global trade, they would be most affected.
2) Fed Rate Hike Cycle: The rise in US rates in late 2016 had some similarities with the Taper Tantrum in May 2013. Fed fund futures for December 2018 rose from 0.95% to about 1.6% by year-end. This is similar to the levels seen in 2013, when markets significantly over-priced the risk of rising US rates (up to almost 1.5% by December 2015). However, macro conditions in EMs are more favourable today, as external imbalances have declined (particularly in deficit countries) and real rate buffers have increased. Inflationary risks from currency depreciation are less pronounced given low capacity utilization in most EMs. Hence, “we think EMs are better able to withstand a gradual increase in US rates. However, some EMs have made less progress on reducing their external macro imbalances and are more likely to be impacted negatively,” the report says.
3) China Slowdown/Decline in Commodity Prices: Investors are similarly concerned that the resolution of China’s debt and excess capacity issues as well as the attendant impact on its growth trajectory would weigh on EMs. Morgan Stanley believes that a sharp deceleration in China would indeed pose major headwinds to the EM recovery, particularly for export-oriented economies in Asia and commodity exporters.
However, “we believe that the slowdown in China will be in a gradual fashion as policy makers will continue with the approach of a gradual adjustment in addressing excess capacity. As a consequence, we think that the risks of a shock emanating from China remain relatively low and constrained to a few countries. With global growth improving and better coordination among oil producers, downside risks to energy prices are probably limited. However, exporters of industrial metals will likely face stronger headwinds as China’s housing starts moderate.
Morgan Stanley, however, says that they do not expect these risks to materialize in their base case, and also think that EMs are now better prepared to face some moderate pressures, thanks to the reduction in macro imbalances. However, risks still have to be monitored closely.