Financial markets hit a wall in the last quarter of 2018. Several shocks negatively affected market sentiment. The U.S. Federal Reserve (Fed) once again decided to hike interest rates, as was nearly universally expected.
Markets were expecting a clear message that the Fed might consider a pause in any future rate increases, but initially that was not communicated. Equity markets sold off, bonds rallied, and the U.S. dollar weakened. The sell-offs were sizeable, which led some to think a recession might be imminent. It was not just the Fed making headlines because some key economic data were weaker in December. In the United States, regional surveys from the Fed and sentiment surveys from the Institute for Supply Management (ISM) deteriorated, and there was also a cool-off in housing. Politics were once again a factor because there was little clarity from the Trump Administration about the policies for tariffs on Chinese imports, and the U.S. government shutdown did not help in an environment where the appetite for risk declined.
China and Asia
Global economic data continued to soften, but current projections still point to global growth for 2018 and 2019 remaining around its historical average. As we enter 2019, U.S. growth momentum may slow as the boost from fiscal stimulus fades towards the second half of the year, while the Eurozone and emerging markets growth should stabilise by the second half, a development that could reduce the momentum gap between the U.S. and the rest of the world.
A slowing China, tightening financial conditions, and uncertainty about the U.S.-China trade dispute were strong headwinds for Asian emerging markets for most of 2018. Third-quarter figures for gross domestic product (GDP) growth highlighted the increasing divergence between the still robust U.S. growth and the rest of the world’s more moderate growth. Since then, the high frequency indicators, such as Purchasing Managers’ Index (PMI) data and export numbers from Asia, point to continuing softer growth in the region, especially in China.
In 2019, we are already seeing some shift in two of three key factors. The first factor is related to the trade dispute, which is still at the top of our mind. The current truce is just that – a temporary lull in tariff wars. There is still considerable uncertainty about whether and when a negotiated agreement can be reached and what it would entail. The broader concern is the impact of uncertainty on business sentiment, investment, and related financial flows as global supply chains adjust.
The second factor is our expectations for a positive change in financial conditions. We do not expect monetary policy to get significantly tighter in most of the region. This view is predicated on several considerations, including the Fed signalling that it may be close to the end of its tightening cycle, already substantial policy tightening in several emerging markets, and the absence of inflationary pressures in most EM countries.
The third factor in which we have not seen a shift yet is the slowdown in China but we expect this to change by the second half of 2019. In addition to the recent monetary and fiscal policy easing, we expect further tax and reserve requirement cuts will support domestic demand and credit markets. These policies may not totally mitigate the external risks to global trade and the region, but they will cushion domestic demand in China and hence the regional emerging markets, as the U.S. economy continues to slow down. Last but not least, with several elections in key EM nations, we also expect economic policies to be biased towards supporting domestic consumption, another cushion against external risks to growth.
In general, divergent developed market monetary policies, with the Fed and European Central Bank at different cycles, set the stage for emerging markets differentiation with those emerging markets that are financially vulnerable likely to see hard economic adjustments. In this world of weaker growth and low inflationary pressure, emerging markets economies may benefit from by tightening monetary policy more slowly if at all. Looser financial conditions could be offset by lower commodity prices and a harsh reduction in liquidity — two developments that would add uncertainty and pressure to EM currencies especially.
The emerging market economies of Latin America and select frontier Africa countries have seen lacklustre growth, and uncertainties about global growth would prevent a meaningful appreciation in the growth cycle for these regions now. Nonetheless, we expect a growth recovery in Latin America for all countries, except for Mexico, where the U.S. slowdown, combined with uncertainties over Mexican government policy, will reduce growth in 2019. Latin American growth as a region is likely to almost double to 2.4% from last year, provided Argentina’s economy stops contracting, and we do believe the economic programme there is on the right track. In Brazil, economic activity remains at a slow pace for now despite incipient signs of improvement, such as the widespread increase in consumer and business confidence indicators. We forecast a recovery towards 3% this year, assuming that progress in the pension reform efforts now underway supports this more benign environment. While outright interest rate cuts in the region are unlikely, the recent guidance provided by the Fed gives many central banks room to wait before removing their own stimulus efforts. Elsewhere, in the frontier fragile economies of the sub-Saharan African countries, there is room for politics to improve with presidential electoral outcomes in 2019 favouring either incumbents or market-friendly candidates.
In December, the European Central Bank (ECB) ended its quantitative easing programme, as widely expected, despite weakening data in the Eurozone throughout the year. ECB President Mario Draghi continued to express confidence in the Eurozone outlook with trend growth above potential and strong Eurozone fundamentals, although there was some recent weakened economic data, which may be temporary. Eurozone data weaknesses seemed to stabilize in the second half of 2018. The underlying forces of growth in the Eurozone, such as job creation and income growth, a revival of bank lending, and high levels of confidence, are intact and growth for the region should remain in the 1.5%-2% range.
The U.S. economy continued to show strong growth momentum, and the tracking of fourth-quarter GDP data suggests the economy finished the year at just under 3% GDP growth. There are pockets of moderation, such as housing and investment expenditures, which may have peaked in the second half of the year. Going forward, investment should continue to support growth. With increasingly less slack in the economy, strong profits, and the corporate tax cuts, the environment for investment is healthy.
Consumers so far do not seem to be affected by the market jitters and politics. Early reports and anecdotes suggest that the holiday shopping period was good. Job growth is still strong, supporting both incomes and consumer confidence. Household finances are in good shape. The Fed has now communicated it will take stock and observe the impact of the monetary tightening delivered so far before potentially resuming any hikes leading to a risk-on start to 2019.
Opportunity for Investors
EM interest rate valuations continue to be very attractive, primarily real yields in the front and long end of interest rate curves. Moreover, the yield curves in emerging markets tend to be quite steep, unlike their developed market counterparts. As global growth, particularly U.S. growth, cools to a more sustainable level, real yields in EM should fall materially over the next 12- to 36-month investment horizon. We also expect the U.S. dollar to be broadly weaker over the same period, with short periodic strength that should be temporary. EM currencies should appreciate somewhat in real terms during that period. In addition, we think that several EM central banks, such as those in India, Indonesia, and Brazil, will want to rebuild reserves as the U.S. dollar falls, a circumstance that could make EM FX more of a carry play.
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