EM: Trump, Jump, Pump or Dump?

Alessia Berardi is a Senior Economist in charge of providing analysis on macroeconomic issues.

Macroeconomic conditions in Emerging Markets (EMs) are much better today than they were at the end of 2015 or the beginning of 2016. In line with our 2016 Outlook, macroeconomic conditions kept improving, supported by a benign external environment led by increasing commodity prices and a very accommodative Federal Reserve. For 2017, we expect EMs to exhibit a very mild improvement from current macroeconomic conditions. The outlook is stable and positive overall with the usual significant divergences among countries.

In terms of GDP growth, a slight improvement at the aggregate level is mainly driven by higher growth expectations in Brazil and Russia after the deep recessions they have experienced. Other countries are not expected to improve their GDP growth by much, while Mexico and Turkey are expected to see significant deterioration.

On the domestic side, the fiscal lever will be slightly more supportive than in 2016, and Asian countries are better positioned to use it because they are generally less fragile (except Malaysia). On the back of our constructive outlook for the commodity space, commodity exporters may decide to loosen their stance sometime during the year if necessary, trimming or delaying their fiscal consolidation plans (e.g., Russia).

Although monetary policy easing is needed in most countries, according to metrics based on output and inflation gaps, room to ease will be limited by the “normalization” process undertaken by the Federal Reserve with respect to US rates. In some cases, notably Mexico, the need for easing in the view of increasingly poor economic performance is completely overshadowed by the focus that the Central Bank (CB) has on currency weakness and its pass-through impact on inflation, prompting the CB to actually hike rates and continue to tighten.

On the external side, we are constructive on the commodity space and on the trade of manufacturing goods in 2017. Regarding the latter, our positive outlook comes from the recent upward revision of growth expectations for 2017 and positive macro momentum among Developed Markets (DMs). Overall, the returns expected in energy and metals sectors are higher than for agriculture and manufacturing goods. Oil and metals exporters (Russia, South Africa, Chile and Peru) are the largest beneficiaries in our outlook.

The best part of the EM Outlook for 2017 is the inflation side. In almost all EM countries, inflation in 2017 will approach/stay within Central Banks’ target ranges. The only exception is Turkey, where high sticky inflation – clearly not at all anchored by the Central Bank of Turkey – will pose some vulnerability to the Turkish outlook. If we divide the inflation picture into two sides, we see a clear convergence of inflation towards CBs target either from the upside (Brazil, Russia and Colombia) or from the downside (Thailand, Poland, Hungary, South Korea and Taiwan).

We do not see any pressure coming from demand next year; rather, the output gap in aggregate terms is still open, although narrowing. However, if we do not see pressure on the demand side, some pressure could come from the cost side, either because of a stronger-than-expected increase in oil prices or because of a further devaluation of EM currencies passing through to inflation.

In recent years, many EM Central Banks have done an excellent job of managing policy. Exchange rate pass-through[1] has been declining mainly in countries with a stable and predictable monetary policy that are anchoring expectations with an inflation targeting framework, letting currencies float and avoiding the use of capital controls.

However, recent producer price index figures are showing some early signals of overheating that, in our view, should not be underestimated (China, Mexico). The case of a stronger USD together with higher-than-expected oil prices (both aspects coherent with Trump’s strategy) could turn benign inflation into a disruptive dynamic, causing concern for EM monetary policy models.

EM Inflation Outlook

Source: Pioneer Investments, CEIC, IMF. Data as of December 15, 2016.

As noted, monetary policy easing needs to remain in place in 2017 for most EM economies. EM countries are broadly growing below their potential rate, with a few exceptions (Philippines above all), and inflation does not represent a constraint, with the exception of Turkey. High inflation countries are witnessing a declining path in the cost of living, converging towards CB targets and, for most of them, inflation is well under control, meaning below or at target.

However, while domestic macroeconomic conditions are supported by monetary policy easing, external financial conditions have been tighter and tighter since the election of the new US President: a stronger dollar and higher rates have been anticipating what Trump could do on the fiscal side and what the Federal Reserve could do on the monetary side.

In the few countries where CBs were behind the curve in 2016 (Brazil, Russia and even Colombia), and where inflation rates have reversed and easing is far from being completed, we still see room for easing in 2017. However, for most EMs we do not see much room to ease going forward and what little room there is will be offset by tight global financial conditions.

In line with the risk that we see on the inflation side, some CBs could be forced to adopt a tighter monetary policy stance to defend their currencies and their mandate on inflation.

Inflation dynamics more than monetary policy will be the driver of real interest rate changes in 2017, in contrast with 2016. Real rates are not expected to change dramatically in 2017, except in countries with very low inflation today, where real rates will decrease due to higher inflation.

The deployment of the fiscal lever last year was higher than anticipated in our 2016 outlook. We do expect at least the same support coming from the fiscal side in 2017, although in a “new” environment of higher rates, fiscal sustainability is becoming more difficult to achieve. On paper, Asian countries appear the least fragile today and the most likely to be comfortable in using the fiscal lever. However, we believe that other countries, like Russia, Chile, South Korea and Czech Republic, will join thanks to low government debt positions, low interest payments as a percentage of revenue and accommodative rates in comparison with growth dynamics (fiscal sustainability law). Notwithstanding that interest payments are almost 10% of revenue, Turkey will continue with fiscal easing to counterbalance its deteriorating economic outlook.

External vulnerability is crucial for determining next year’s outlook. Since the “taper tantrum” episode in 2013, EM vulnerability has decreased in aggregate terms, but we can’t say that EMs are free of concern. Aggregate basic current accounts (Current Account balance plus Foreign Direct investments, Ex-China) have become positive since the end of 2014, thanks to some adjustments made by the so called Fragile Five (in particular India, Indonesia and Brazil). However, vulnerability conditions, measured by a group of indicators including balance of payments, external debt and reserve ratio adequacy, remain quite heterogeneous, with India appearing to be the safest country in the EM universe and Turkey the riskiest one.

Considering a number of variables (macroeconomic conditions, fiscal and monetary policy, debt and leverage, external vulnerability measures) we can see the 2017 rank for EMs in the graph below. India continues to be the most appealing country, followed by Indonesia and Russia.

EM Heat Map

Source: Pioneer Investments. Data as of December 15, 2016. The final score is calculated as sum of single items.

[1]Exchange rate pass-through is defined as the effect of exchange rate changes on domestic inflation.