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The mood on the sidelines of the IMF Spring Meetings in Washington, D.C. was decidedly more upbeat than last October as several of the headwinds that challenged the emerging market asset class last year have faded and turned into potential tailwinds. The US Federal Reserve (FED) is expected to let the economy run hot again, EM growth is seen as potentially on the mend as more signs accumulate to indicate that China’s growth troughed in the first quarter of 2019, and global policy uncertainties on trade and Brexit have been, for the most part, fading. There is, however, less certainty on the future direction of the US dollar until and unless we see a firmer recovery in Europe. While the current set-up is broadly supportive for EM, the bottom-up story is not uniformly compelling, therefore, requiring a higher degree of caution when selecting assets. In credit, where valuations are less compelling following a significant rally in US Treasuries (UST) that we feel has run its course, we believe that the upside will largely need to come from the cheaper-looking credits in high yield
We feel that the top-down macro backdrop has become more constructive for EM, in line with our “What to expect in 2019” feature, which was published in December 2018. US growth has been moderating while still above potential, inflationary pressures in the US have been subdued, the FED is likely to be on hold for the rest of the year, and the likely switch to an alternative average inflation targeting framework over the next 6-12 months establishes a high hurdle to resume rate hikes. Growth concerns in EM have, in our view, somewhat receded now that China’s growth slowdown is bottoming, with increasing evidence that the lagged impact of China’s past monetary stimulus has resulted in a credit rebound while recent fiscal stimulus measures should likely help the recovery gain traction over the next two quarters. The size of the stimulus is smaller than in 2015 and 2016 and more inward looking. While we believe that the supply-demand imbalances in the property sector will slow down any upward momentum over the medium-term, removing China as a drag for the more open economies of Asia and Europe is already a significant positive.
Policy uncertainties related to trade and Brexit have also been, for the most part, fading. The US and China have made some headway towards resolving their trade differences, although they seem to have hit an impasse as they get closer to finalizing terms that we think could introduce some near-term volatility. We believe that the US is also unlikely to impose broad tariffs on imports of autos, despite recent threats to do so, and will instead use it as leverage in trade negotiations with Europe. The threat of a disorderly hard Brexit, which could be disruptive to a European recovery, has also diminished recently after the majority of MPs ruled out that possibility, and the UK government agreed to participate in European Parliamentary elections to secure an extension of negotiations until the end of October.
There is, however, less certainty on the future direction of the US dollar, with a growth slowdown and dovish FED on the one hand, and the continued lagging recovery in Europe and higher carry compared to other G10 currencies on the other. Until the European recovery gathers further steam, we believe that the uncertainty over the US dollar is likely to continue to be a relative challenge for EM. European growth appears to have bottomed out thanks to a robust labor market, loose fiscal policy, and easy financial conditions, but it will be critical to see if reduced global trade policy uncertainties can help the manufacturing sector recover and allow for a broader lift-off.
While the current top-down macro backdrop is broadly supportive for EM, the bottom-up perspective is seen as more challenging and differentiated, making it imperative to be careful when selecting assets. In credit, we see valuations as generally already fair to even slightly rich after a significant tightening in spreads on the back of a UST rally that we feel has already run its course. While we are comfortable collecting carry in select oil-exposed, fundamentally sound credits, we believe that the upside will largely need to come from cheaper-looking credits elsewhere.
In Argentina, the prospect of an increasingly tight three-way election has weighed on assets where positioning was already crowded, though at this point we estimate that the market is slightly overpricing the possibility of former President Cristina Fernández de Kirchner coming back to office. Meanwhile. in Turkey, near-term prospects appear more challenging after President Recep Tayyip Erdogan decided to force a re-election in Istanbul on June 23 that will further postpone a return to the deleveraging policies of the fourth quarter of last year.
In local rates and FX, we continue to look for idiosyncratic opportunities and currently favor select rate receivers. Running yields in Egypt continue to be potentially attractive thanks to the prospect of a further cut following the 100 basis points rate cut last February, Egypt’s improved external position and foreign inflows have allowed the banking sector’s net foreign asset deficit to move back into balance. Running yields in Nigeria are not quite as attractive, however, we believe that FX risk is lower than in Egypt given recently re-elected President Muhammadu Buhari’s preference for continuing to run a relatively fixed FX regime. The Central Bank of Nigeria typically only allows a significant FX realignment if external factors, such as the sharp decline in oil prices in 2014 and 2016, put heavy pressure on the balance of payments. This is clearly not the case today, and we foresee limited to no adjustments unless Brent oil prices were to fall sustainably below USD 50 per barrel.
We think that Brazil and Mexican markets could potentially offer opportunities. In Brazil, our base case remains that the approval of the social security reform bill towards the end of the third quarter of 2019 could help anchor Brazil’s fiscal dynamics for the best part of the next decade. Coupled with subpar growth, subdued inflation, and a high unemployment rate, we believe that this should likely provide reasonable justification for the Central Bank to either cut rates or remain at current rates for far longer than the market expects. In Mexico, disappointing growth, the prospect of inflation falling within the 2% to 4% band in the second half of the year, and a so far disciplined fiscal stance should also prompt the Central Bank to begin a deeper rate cutting cycle in the second half of the year than what we believe is currently priced by markets.