China and oil prices are key in the short term

It seems that calm has been restored following the dramatic fall-out in equity markets over the past week triggered by the turmoil in emerging markets (EM). The question is whether or not this is sustainable. In the short term, we believe two factors will be decisive.

• China: A key driver for EM assets is the development in China. An important factor behind the current EM rout has been related to the very weak development in China and fears of a hard landing. The market tends to focus a lot on PMI and has paid less attention to other data that have pointed to recovery in housing, so the development in PMI in coming months is important. If PMI fails to recover, the policy response will be important. It has to be strong enough to convince the market that a recovery will come eventually.

• Oil prices: Another major factor putting pressure on EM is the sharp decline in oil prices – and prices for other commodities too. Countries such as Brazil and Russia are already in deep recession and the pain is growing by the day, with a further fall in commodity prices. Brazil is heading for recession of -2% this year, the worst performance in 25 years, and we expect Russia to face a decline of 5% in GDP in 2015. Stress is also rising in the Gulf region and the biggest African economy Nigeria. A further decline in oil prices might break the camel’s back and lead to a financial event in one of these countries that could add to fears over EM.

So, what should we expect on these fronts? When it comes to China, we believe it has the tools needed to avoid a hard landing and orchestrate a slow recovery in H2. The moderate easing this week shows it is likely to move gradually and evaluate as it goes along. China has an aversion to big stimulus plans, as it has its eyes focused on a continued structural deleveraging and focuses on economic and financial reforms. However, it is unlikely it will allow a further deterioration of the economy without stepping harder on the gas, as this could become a threat to social stability and weaken the Chinese leadership. Regarding oil prices, the short term call is tough, as it depends on how big the oil glut is in the short term. However, we believe prices are far below marginal production costs now and that a moderate recovery in China will lead to a very gradual rise in oil prices over coming quarters.

If the above falls into place, we believe it is enough to stabilise the situation. A joker is the looming lift-off from the Fed. If markets calm down, the Fed is on track to raise rates – our forecast is that this will happen in December. This will be another test of the fragility of EM.

US and euro data still robust

On a positive note, developments in both the US and the euro area continue to be robust and point to continued recovery. US GDP for Q2 was this week revised up to 3.7% q/q annualised (from 2.3%) and durable goods orders pointed to a recovery of US investment growth in Q3. Initial jobless claims have also stayed at very low levels pointing to a robust job market and continued decent growth in Q3.

In the euro area, the German ifo index and French business confidence for August both increased from solid levels giving support to our case for a moderate rebound in growth in H2. Real M1 growth also still points to continued recovery into 2016.

The data does not include effects from the latest shock but we don’t believe the latest turmoil is enough to derail either the US or euro recovery. Our calculations based on exports to EM and the effect of the currency appreciation versus EM shows that the EM rout should so far only have a limited effect on economic activity. The unknown is how big a sentiment effect we might get that could make business reduce investments and hiring. We do expect some sentiment effect but overall mainly see the turmoil as reducing growth in the magnitude of 0.1-0.2 percentage points over the coming quarters.

Keep an eye on Russia and Brazil and US oil sector

While the above factors should help facilitate a stabilisation, there are risk factors that bares close watching. One fear is that a financial event takes place in some of the above mentioned regions – Latin America, Russia, the Gulf region and Africa (major commodity exporter). Stress is also rising in the US energy sector as witnessed by the sharp rise in high yield spreads within the energy sector which constitute close to 20% of the high yield spectrum. If bankruptcies start to take place it will create negative headlines that could hit sentiment.