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Looser in emerging markets, tighter in developed: can the trend continue?

Last year, a combination of recovering but still below-potential growth and falling inflation allowed the central banks of many emerging markets (EM) to continue easing their monetary policy, even as developed market (DM) central banks, led by the US Federal Reserve (Fed), were shifting into tightening mode (see Exhibit 1).

Last year, a combination of recovering but still below-potential growth and falling inflation allowed the central banks of many emerging markets (EM) to continue easing their monetary policy, even as developed market (DM) central banks, led by the US Federal Reserve (Fed), were shifting into tightening mode (see Exhibit 1).

The deepest cuts were delivered in economies with high-yielding government bonds such as Brazil, Colombia, Russia, Chile, Peru and Indonesia. The Indian and South African central banks also cut their rates.

Exhibit 1: Central bank policy rates Looser monetary policy in emerging markets, tighter in developed: can the trend continue?

Note: DM average of Australia, Canada, Denmark, eurozone, Iceland, Japan, New Zealand, Norway, Sweden, UK and US. EM average of Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Poland, Romania, Russia, South Africa, Taiwan and Thailand. Source: Haver, BNP Paribas Asset Management, as of March 2018

2018: the likely developments in emerging markets

Expectations are for the Fed to shift around mid-2018 to projecting a total of four increases in the fed funds rate for the year. While well behind the Fed in the monetary policy cycle, the ECB looks to be on track to taper its quantitative easing in Q4 2018 and deliver its first rate increase of the cycle in mid-2019.

At the same time, China's leader, Xi Jinping, is in a stronger position politically, allowing him to address more forcefully the country’s internal credit and debt-related imbalances.

The combination of these factors appears to leave EM local currency debt and currencies (FX) more vulnerable compared to last year.

Add to this rising protectionism-related market volatility, political uncertainty in developed economies – for example the ongoing Brexit negotiations, Italy’s difficulty in forming a government and the US mid-term elections later in the year – and EM’s own dense political calendar, and the case for owning EM debt and FX is arguably looking less bright.

That said, from a macroeconomic perspective, emerging markets remain in a sweet spot of historically low and contained inflation and a growth recovery that is still catching up to the more mature growth cycle in developed markets.

Monetary policy diverges between developed and emerging markets

To be sure, with most of the EM easing cycle now behind us, this year’s EM-DM monetary policy divergence should be limited to high-yielding EMs. For example, so far this year, we have seen Brazil, Colombia, Peru, Russia and South Africa all cutting policy rates further.

Downside surprises on inflation, with traditionally large and volatile components of the CPI basket such as food and energy becoming more stable, could mean that EM central banks can eventually lower their estimates for the neutral policy rate. This means that EM yields could continue to move lower on expectations of such a policy shift.

On the flip side, low-yielding countries such as Mexico, the Czech Republic, Romania, South Korea and Malaysia, have all begun gentle and gradual tightening, narrowing the rate differential. In India, Thailand and Israel, monetary policy committees, while all still in wait-and-see mode, have shown nascent signs of hawkish dissent.

Which factors could prolong or interrupt this monetary policy divergence?

For low-yielders with trade-surplus economies such as South Korea, Taiwan and Thailand, increased noise on trade and currency wars from US President Trump’s administration could hit investor confidence and cause greater market volatility. This could dent their growth momentum and thus delay the pace of monetary tightening.

For low-yielders with a high beta to eurozone growth (Poland, the Czech Republic, Hungary and Romania), where wage growth and labour markets appear to be at their tightest in years and output gaps are now largely closed, central bank tolerance to rising inflation likely means a potential disorderly pick-up in inflation followed by aggressive policy tightening.

Domestic politics: Brazil and South Africa are the two most recent examples where corruption scandals have become a major driver of change, allowing central banks to ease policy thanks to the tighter fiscal and pro-structural reforms stance. In Russia, on the other hand, a tight fiscal stance was one of the major disinflationary drivers allowing the central bank to cut its policy rates. We now see risks for looser fiscal policies, limiting the scope for further easing.

For the high-yielders and commodity exporters in Latin America, there is ample slack in the regional economies, but less supportive base effects after the first quarter this year may mean that inflation will rise, although only gradually. This should allow central banks either to cut rates further or leave policy on hold for longer.

From an external perspective, gradual and shallow monetary policy normalisation in developed markets – as long as this is accompanied by higher growth spilling over into EM growth – should not be too disruptive for emerging market assets.

Higher EM growth this year compared to 2017: although we saw another deceleration in overall EM GDP growth in Q4 2017 from the preceding quarter, growth levels in H1 2017 were revised upwards.

One should also keep in mind some purely domestic one-off factors that weighed on EM growth in 2017:

  • in India, growth was disrupted by the introduction of the Goods and Service Tax reform, which should be positive for growth in the medium term
  • in Russia, there were large swings in gas exports - strong in the first half year, but weak in the second - a decline in nuclear fuel production in Q4 2017 and less arms procurement
  • in South Africa, the leadership struggle weighed on business confidence and growth, but the new leadership is generally seen as a positive structural outcome for medium-term growth
  • Mexico was hit by a powerful earthquake
  • in Chile, election uncertainty held up investment
  • an oil refinery shutdown in Uruguay affected output.

Put another way, had these factors not arisen, emerging market growth would likely have been stronger in 2017. Fading one-off disruptions and the ongoing recovery in developed market trend growth led by the EU and the US should support EM growth and therefore selected local currency debt markets.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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