Emerging Markets: Ample negative risks in 2018 - Nomura

Analysts at Nomura explain that after looking at pricing and positioning in various markets, it suggest that investors believe the global economy is in a ‘sweet spot.’ It is reflected in the tightness of EM credit spreads, at lows not seen since before the US financial crisis, and substantial foreign bond and equity inflows with some markets at or near record high holdings (foreign ownership of equities as a percentage of market capitalisation is at 34.6% in Korea, 39.8% in Taiwan and 47% in Brazil; foreign ownership of bonds as a percentage of outstanding is at 40% in Indonesia, 32.6% in Mexico, and 51.4% in Czech), they further add.

Key Quotes

“Global EM FX and equity market volatility are also subdued, with EM FX vol2 at multi-year lows and VIX near record lows3. Thus, the negative impact on EM FX and rates markets could be exacerbated (by the extended positioning) from the emergence of a major risk event:

1. China economic/financial stress: The government’s drive to reduce financial leverage has led to a widening of credit spreads in China fixed income markets, raising the risk of slower growth and more defaults. China equities have been under pressure from the government’s targeting of leverage and excesses in real estate, financial and industrial sectors. Although the rise in credit spreads and defaults have been contained (thus far) and spill-over effects on broader China, Asia (primarily Northeast Asia FX and SGD), and EM (BRL and CLP) markets have been limited, the focus on reducing leverage through 2018 will continue to pose a significant risk to Asia/broader EM markets.

2. A pricing in of more US rate hikes: Our economics team raised their US 2018 GDP growth forecasts to 2.5% from 2.2% (on 21 October), raised their US rate hike forecasts to an additional 25bp rate hike in 2018 and in 2019 (now three 25bp hikes in 2018 to 2.125%), and still forecast an increase in core PCE to 1.9% by end-2018. This optimism highlights the risk that there will need to be a repricing of Fed hikes by the market, with Fed fund futures through end-2018 only pricing in +63bp of hikes (versus our economics team’s forecasts and Fed dots of +100bp over the same period). This is a potential source of support for USD/EM and higher rates in EM – especially in a rapid repricing scenario. However, in another scenario, Fed hikes could be notably negative for EM.

Given lags, there is a risk that we could move into a phase of the cycle where inflation eventually rises, but when growth is actually slowing (output gap is still positive). This combination of slower growth, rate hikes, falling PE multiples, widening credit spreads etc. would be a significantly negative scenario for EM. EM countries susceptible to this scenario include those in which foreign portfolio positioning is relatively high and/or basic balance positions are negative/close to balance.

We believe that foreign equity positioning is high in Korea, Taiwan and Brazil, while local debt markets in Indonesia, Mexico, Colombia and Czech stand out. On basic balance positions, most of EM (disregarding USD hoarding risks) have relatively weak basic balance positions, with Korea, Taiwan, Thailand, China, Brazil and Russia as key exceptions.

3. ECB and Fed policy normalisation: Nomura economics expects the ECB to announce in the middle of 2018 that it will cease its EUR30bn in monthly asset purchases from September 2018. Indeed, the ECB may begin hiking rates by end2018. We believe the combination of Fed and ECB policy normalisation could pose a risk to capital inflows into EM, although the EUR strength expected by our G10 FX team represents a potential offset.

4. Higher oil prices: Stronger global growth and supply side concerns are risks that could drive higher oil prices. The supply side focus is on the Middle East, specifically the tensions surrounding Saudi Arabia and Iran. Our discussions with political analysts peg the probability of a war between Saudi Arabia and Iran at around 20% within the next six months. Clearly, a surge in oil prices would lead to a noticeable differentiation among EM FX, with India, Philippines, and Turkey (India twin deficits and trade and inflation impacts on Turkey and Philippines) likely the biggest losers. On rates, upside pressures would be prominent in Taiwan, Thailand (curve steepen), Czech and Poland.

5. US/Trump trade protectionism and North Korea are more tail risks: A US-led trade war would ultimately hurt US/global growth, but protectionism targeted at China would be most negative (beyond China) for Northeast Asia FX, SGD and MYR. This could eventually feed through to protectionism with Mexico. A severe deterioration in North Korea political risks would be most negative for KRW and Northeast Asia FX, but the negative risk impact would likely impact broad EM.”