Shifting attention from geopolitics to Fed tightening

Geopolitical fears have dominated emerging market sentiment nearly all year. However, as geopolitical fears seem to be easing on the back of the – admittedly fragile – ceasefire in eastern Ukraine other concerns are showing up.

Paradoxically, it is good news for the US economy that might start to worry emerging markets investors. Hence, in recent weeks, US macroeconomic data have continued to surprise positively and this has caused investors to fear that the Federal Reserve could initiate monetary tightening earlier than thought. This has caused US bond yields to rise and this is not normally good news for emerging markets sentiment and consequently we are seeing some emerging markets coming under pressure on the back of this.

Furthermore, markets continue to worry about the strength of the Chinese economy and recent Chinese economic data have added to these fears.

The combination of weaker Chinese data and Fed tightening fears is not exactly a good cocktail for emerging markets, particularly not for commodity-exporting emerging markets. Indeed, in recent weeks, we have seen some weakness in global commodity prices and this is beginning to weigh on some emerging markets.

As a direct consequence of these factors we have changed our forecasts in a more negative direction for some of the more commodity sensitive and US sensitive emerging market currencies. Most notably, we have become somewhat more negative on the Mexican peso and we would certainly fear that the peso could take a further beating if the Fed were to step up its hawkish rhetoric at this week’s FOMC meeting.

While the Fed seems likely to start moving in a more hawkish direction, deflationary fears remain in Europe – not only in the eurozone but also in the Central and Eastern European economies. Consequently, we expect the CEE central banks to move towards monetary easing to curb deflationary pressures. This, combined with more expectations for the Fed, is not exactly good news for the CEE currencies (particularly against the dollar).

Concluding, even with geopolitical worries easing, we are still seeing some headwinds for the emerging markets. This said, we should also stress that the markets are pricing a more hawkish Fed exactly because the US economy is doing better and that is unlikely to be bad news for emerging markets over the longer term. Consequently, we see the biggest emerging market risks from US monetary policy on a three- to six-month horizon, rather than on a 12-month horizon.