EMs – Are we on the verge of a rally?

Macro

Christopher Dembik

Head of Macro Analysis

Summary:  We believe we are at the early innings of an EMs rally that could materialize in early 2020, fueled by improved growth, less trade war frictions between the US and China and a weaker dollar.


Our central scenario: We expect that higher central bank liquidity combined with improving US and China credit impulses will reflect positively on economic growth in Q1-Q2 2020. On the top of that, we think that we are approaching the end of the strong dollar cycle and that idiosyncratic US political risk ahead of the 2020 election will push the USD lower. It could motivate investors to move away from a defensive portfolio and have a more positive bias towards EMs.

Trade war frictions remain the top main risk in the short-term

Our FX Risk indicator, based on the evolution of Asian Currencies (ex. Japan) vs the USD, was out in contraction at minus 1.3% Q/Q in Q3. The contraction is less important than during the previous episodes of trade war tensions, especially in 2018. However, it is a reminder that trade war remains one of the main risks for EMs in the short term.

We still think a mini trade deal between the United States and China could be reached in November, when the APEC summit will take place. This does not mean that trade tensions will disappear overnight, and that global trade will escape from recession. Indeed, the risk is elevated that the Trump administration will turn to Europe and has a more radical approach to force Europeans to make trade concessions. Nonetheless, such a mini deal could temporarily have a positive effect on confidence and growth momentum, and it could give a boost to emerging countries that are among the most dependent on manufacturing to growth, especially in Southeast Asia.

If a currency pact is also part of the mini deal, and that the CNY remains stable, as it has been for several months, it could also push the Dollar Index lower, which would be another reason to be positive on EMs.

The USD has likely reached its cyclical top

The rise of the USD since April 2018 has been one of the most important drivers of asset performance over the past 18 months and has played a key role in EMs performance along with trade war tensions. The stronger Dollar Index has resulted from risk aversion but, foremost, from lower US dollar liquidity in the international financial system.

We now see limited upside for DXY and consider we are approaching, or we already are, at the end of the strong dollar cycle. We identify four factors that should push the DXY lower in coming months: improving central bank liquidity, in relation to the new accommodative stance from global central banks, positive effect of US and Chinese credit push on growth, US-China trade truce and idiosyncratic US political risk due to the 2020 presidential election. On the top of that, we should not forget that the United States desperately need a lower USD, even more than usual as the election period is kicking off. If USD weakness is about to start, as we firmly believe, it could be a decisive driver for EMs rally into 2020.

EMs have started to accommodate the global slowdown

 As I have recently said to Bloomberg, what is interesting contrary to previous periods of slowdown is that all EMs have room to make a monetary of fiscal push in order to stay afloat. No country is constrained on both policies and some of them, notably Russia and South Korea, can even accommodate on both. It should be supportive for EMs high quality debt in the medium term.

Aside from the example of these two countries that I discuss longer in the interview, we also have very positive trends emerging in two other emerging markets, especially regarding fiscal push:

  • Indonesia proposed a 2020 budget including an increase of 8% of actual spending and announced a 5-year plan to spend a more significant portion of its GDP in infrastructure. It is also looking to lower corporate tax and to attract more foreign investment via promoting foreign ownership of local companies. The recent appointment of Gojek founder in the cabinet by President Jokowi can also be perceived as an effort to make the economy more tech-oriented and to facilitate the emergence of new faces that are more business-friendly. In addition to that, the Indonesian central bank is also lowering rates and we expect, aligned with the consensus, that it will cut rates by 25 basis points this week.
  • India announced in mid-September a surprise corporate tax cut from a range of 30%-40% to 22%-25%, amounting for approximatively 0.7% of India’s GDP. The country is becoming a key growth player as it is expected to beat the United States in global economy growth share by 2024 according to the IMF. However, more reforms are needed and will certainly be delivered soon in terms of tax policy in order to be in line with other Asian countries.

Until the positive factors we have mentioned in this report are confirmed, we reiterate the need for selectivity and see more upside potential in Asia than in Latin America, where the path of reforms is slowing down sharply and where social unrest questions the ability of elected members to implement a reformist agenda.

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