Cyclical outlook

Global Interdependence and Local Politics Weigh on Emerging Markets

Emerging markets are dominated lately by global drivers, including China, the Federal Reserve’s policy stance and lower commodity prices.

In the following interview, Michael Gomez, head of emerging markets portfolio management, and Lupin Rahman, global head of sovereign credit, discuss the conclusions from PIMCO’s quarterly Cyclical Forum, in which the company’s investment professionals debated the outlook for the global economy and markets. They share PIMCO’s outlook for the emerging markets (EM) over the next 12 months.

Q: Emerging markets have made global headlines of late. What is PIMCO’s outlook on EM?
Michael Gomez: Emerging markets’ performance and fundamentals are being dominated lately by a combination of global drivers, including China’s slowdown, the Federal Reserve’s policy stance and lower commodity prices. In addition, politics and upcoming elections are increasingly taking center stage, adding a layer of idiosyncratic risk to the outlook. As a result, emerging markets are facing a number of headwinds that are translating into slowing growth rates and a more challenging macroeconomic backdrop for policymaking.

Over the next 12 months, we expect BRIM (Brazil, Russia, India, Mexico) growth to average around 2%-3% year-over-year, increasing from the current rate (0.3%), but with important downside risks as China slows and EM in general struggle to find a growth model outside of exports and commodities. On the inflation front, we expect BRIM consumer price inflation to decline to around 5%-6% from the current 8.4% given limited pass-through from weaker currencies and the disinflationary impact of lower commodities. Looking ahead, recent declines in producer price inflation suggest further potential downside risks to our baseline forecast.

Q: What are the implications of the China slowdown and the devaluation of the yuan for the rest of EM?
Lupin Rahman: A key theme of the last decade has been the shifting macro-dependence of EM, with China now playing an increasingly important role in the macro outlook for most emerging markets – not just in Asia. The channels of influence include real linkages through China’s role in global trade and commodities, financial linkages as developments in China increasingly drive global risk sentiment and price linkages as the internationalization of China’s currency continues.

We are already seeing the impact of slowing growth in China on commodities and on the growth rates of EM economies with trade linkages to it. We expect Asian currencies to remain under pressure as they lose relative competitiveness with China due to the devaluation of the yuan. More broadly, the risk-off sentiment due to China developments and the continued strength in the U.S. dollar are likely to keep the pressure on most emerging market currencies, which are acting as the release valve for their economies. This, together with large output gaps, are allowing most EM central banks to hold rates unchanged or even to cut in response to weak domestic conditions.

Q: Turning to Brazil, in a recent publication on the global economy, PIMCO noted that domestic politics play a large role in the country’s macro outlook. What political or other developments need to occur for Brazil’s outlook to improve and how likely are they?
Rahman: The political backdrop in Brazil is very fluid given the low approval for President Rousseff and the ongoing corruption scandal known as “Operation Car Wash,” which is overshadowing the day-to-day legislative role of the Congress. Our base case is for President Rousseff to remain in power, but this is unlikely to be a stable equilibrium and carries a non-trivial risk of tipping into an impeachment scenario or a collapse in governability.

Given this backdrop, the macro outlook – which is already weak – will be largely a derivative of domestic politics. Add to this negative market technicals on the back of the S&P credit rating downgrade to BB with a negative outlook, and the result is Brazilian assets are likely to remain highly volatile and prone to overshoots in both directions over our cyclical time frame.

The main factor still supporting Brazil is that the risk of a sovereign external default is low, based on the strength of Brazil’s external balance sheet, low external debt ratios and high foreign exchange reserve coverage for external liabilities coming due. Moreover, the Brazilian central bank remains an important policy anchor for the macroeconomic framework as well as for the efficient functioning of the currency market. It would not take much to turn things around in Brazil, but importantly, stabilization of political dynamics would have to come first.

Q: Russia seems less top-of-mind among economy watchers these days. How did Russia stabilize its markets and are there any lessons for other emerging markets?
Gomez: In Russia, the central bank’s foreign exchange repurchase (repo) operations earlier this year provided massive support for Russian external liabilities by removing uncertainties over “Russia Inc.’s” ability to repay U.S. dollar-denominated debt.

Essentially, banks were allowed to pledge corporate debt (mostly from systemic companies from a pre-determined list and including U.S. dollar-denominated paper) in exchange for foreign currency from the Bank of Russia’s reserves at a very low cost. The result was that corporates with heavy debt amortizations used their local bonds as collateral to raise cheap foreign currency financing and repay external debt (via local banks); and many banks used the repos as a means to fund carry trades, i.e., they borrowed U.S. dollars from the central bank at Libor+50 basis points (bps) and bought Russian corporate eurobonds at Libor+500 bps.

The repo operation was an important crisis-containment tool, which we think could be suitably adjusted to other economies experiencing negative market technicals that are unrelated to the quality of the underlying credit ‒ for example, Brazil.

Another supportive factor in Russia was the coordinated response by all the key policy officials, including the strong support of the President and the Duma. This meant everyone was cognizant of the risks in not containing the situation and was working toward the common goal of stabilizing the markets and the economy. We are not seeing that yet in Brazil, and until we do, it is likely that its macro picture and markets will continue to deteriorate.

Looking ahead in Russia, we expect GDP to contract between -4.0% and -3.5% this year and around -0.5% in 2016. Meanwhile, the disinflation trend is set to continue; and because the impact from the ruble’s weakness has been relatively contained, the central bank will be able to continue to cut interest rates at a moderate pace. Importantly, we expect the improvement in Russia’s external balance sheet to continue as the current account surplus improves and the corporate sector continues to deleverage.

Q: Rounding out BRIM, what is PIMCO’s outlook for Mexico?
Rahman: We are constructive on Mexican assets and expect the economy to fare current global headwinds relatively well. We are forecasting growth in the 2%‒3% range and inflation of about 3% over the next 12 months with limited impact via the peso. This should enable Banxico to move lockstep with the Fed given the strong interlinkages between the two economies and local rates markets. The recent pace of reforms in the energy sector has disappointed relative to our expectations, but the government has progressed on fiscal consolidation, which we view as important to anchor the credit quality of the economy and lend credibility to Banxico’s monetary policy stance.

Q: What are the investment implications of PIMCO’s macro outlook for emerging markets? When should investors jump back in?
Gomez: High growth rates and low debt burdens relative to developed countries continue to underpin the case for investing in emerging markets. Additionally, after years of improvement in institutional strength, many EM countries are better able to defend against global macroeconomic shocks through currency flexibility, monetary policy easing, fiscal policy stimulus and improving domestic consumption patterns.

Unfortunately, the recent bout of shocks also highlights the cyclical risks that many EM countries are still vulnerable to, including commodity cycles, political turmoil and periods of market volatility and risk aversion.

As a result, we are cyclically cautious EM. Still, we have reserved “dry powder,” so we are ready to add exposure where we see attractive risk/reward. We are already seeing value being created in select emerging markets and are looking to be more opportunistic in scaling into positions given the more uncertain global backdrop. Broadly speaking, we like short positions in EM currencies versus the U.S. dollar, underweights in EM credit and long positions in select EM local rates where currencies and yields have adjusted significantly and are pricing in large policy rate hikes over the next year.

The Author

Lupin Rahman

Head of EM Sovereign Credit

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