In 2018, one issue for emerging market (EM) debt was that growth was very unipolar: we had decent growth out of the US but it was fairly lacklustre in Europe. This was partly due to a succession of special factors: new pollution regulations knocked the car industry, low water levels in the Rhine impacted manufacturing and yellow vest protests in France were widely disruptive. The Brexit fiasco has not helped, either.
We believe the outlook for this year is for slightly more balanced growth that will reduce the global economy’s dependence on the US. That should mean the US dollar will not have such a strong year, which would be supportive for EM. Typically, if there is a 1% move in the US dollar against G10 currencies, the EM currency index moves 1.5% against the dollar, so a strong dollar can be a problem for EM asset prices. One positive going forward is that the Federal Reserve (Fed) has clearly shifted into more dovish territory: from pricing three or four rate hikes this year, the market is now pricing in a cut.
Nevertheless, our outlook for US growth is for a modest slowdown toward trend. Past periods when the country has tipped into recession have typically been the result of excessively fast credit growth, with either the Fed hiking rates aggressively to bring down inflation and crimping growth, or a credit bubble bursting of its own accord as debt is no longer repayable. With credit growth in the US still below 10%, we see only a modest probability of recession in the near term. Last year US growth received an additional boost from the very loose fiscal policy of the Trump administration. Given the fiscal impulse will fade this year, we think the most likely scenario is that the economy continues to tick sideways at the current rate of 2.5%.
One thing to draw attention to is the fact large US fiscal deficits could start to weigh on the dollar. The tax cuts pushed through last year mean the US will be running a significant deficit of around 3 to 3.5% of GDP, even in peak cycle years when it would perhaps be expected to run a surplus. If the economy does slow down from here, any further fiscal loosening would likely result in a weaker dollar.
Where could growth pick up? Unfortunately, the recent data out of Europe has not been especially encouraging. The same factors that dragged down Europe in 2018 have continued to afflict the continent, though we think this should begin to improve. Early forward-looking indicators in Europe, particularly regarding the credit impulse, look relatively positive. As a result, we think it is reasonably likely that output in Europe will stabilise.
The Chinese authorities have been trying to bring down credit growth and reduce the overall debt burden in the economy. However, in the short term a sharp pickup in lending at the start of the year should translate into stronger activity. Chinese growth, especially via construction and manufacturing, is a big driver of commodities. China takes 10% of global oil output, around half that of the US – but it consumes about 54% of iron ore output, 27 times as much as the US. For copper, nickel, iron, coal and cement, China is by far the biggest consumer in the world. This is important for South America, as well as countries such as Malaysia and Indonesia.
This brings us to the outlook for EM fixed income. The balance of payments is a key driver of EM FX, while local currency bonds are closely positively correlated with FX. A big driver of inflation is the exchange rate. When a currency depreciates, inflation picks up, interest rates spike and bond returns are poor. We are encouraged by the EM trade balance, as shown in Chart 1 below. (We have excluded China from this analysis as presently it is not an investable market from a fixed income point of view and its trade balance is so huge that developments in China tend to dominate).
Chart 1: EM trade account back into surplus
After deteriorating for much of last year, during which EM currencies underperformed, the EM trade balance has seen a sharp correction back into positive territory. Historically, this has been a good indicator of performance. Through the first decade of the century, when EMs were running trade surpluses, asset class returns were healthy. Going into 2008 EM were overheating, importing a lot more than they exported, and the result was a terrible year for the asset class. The post-global financial crisis recovery was followed by another deterioration in 2013 which came to a head with the “taper tantrum”. The asset class experienced very good years in 2016 and 2017 and, after a deterioration in the balance in 2018, now we are back into surplus territory.
The recent recovery has been driven by non-Asian economies, which are less vulnerable to the stronger oil price. Now the oil price has fallen we may begin to see Asian trade balances recover, too, especially if China picks up.
Encouragingly, there are not any markets which look fragile in terms of external balance. Last year a successful active view was to avoid Turkey for most of the year as the country’s fundamentals deteriorated. Argentina also delivered poor returns – again, a country with a large external deficit which resulted in a big currency devaluation. While we are unenthusiastic about Romania and we see vulnerabilities in India, we do not see any country being as vulnerable as those two were in 2018. Turkey and Argentina suffered losses of 30 and 40% respectively last year, mostly due to currency weakness, but exacerbated by the effects of currency weakness on inflation. As growth accelerates, imports invariably pick up, too: there is only a short-lived window when we have a combination of decent growth and robust external balances, and we think we are currently in the sweet spot.
So what are the risks to EM debt at present? Number one is the stronger dollar. For investors who are able to, we have found investing in EM FX out of euros, or – better still – out of Canadian dollars or Australian dollars can be an excellent way of managing that risk.
Risk number two is related: the US rate hiking cycle. If the US continues to grow strongly, inflation concerns could flare up and lead to higher interest rates. Alternatively, the Fed could decide its neutral position is somewhat higher than where it is at the moment. Either way, if the rate differential between the US and the rest of the developed world continues to widen it could result in a stronger dollar. At the moment we believe those risks look contained. We are much more worried about growth weakness in Europe than inflation in the US, but it is something we need to keep monitoring.
Turning to the trade war, the focus of the Trump administration has been on the manufacturing sector as jobs have gone to countries such as Mexico and China. So it is important to consider the vulnerability of a country in terms of the degree of its exposure to the US. Countries such as the Czech Republic and Hungary are very manufacturing dependent but do little trade with the US and therefore look fairly invulnerable; you also have commodity exporters which are much more dependent on China. The country which has the most exposure to the US is Mexico, but we think its outlook is reasonable from here. The new deal that replaces NAFTA, the USMCA, gives Mexico around 80% of the trade it had under NAFTA, significantly better than the market was anticipating.
In conclusion, we believe there will be a rebalancing of global growth away from the US and towards China and Europe in 2019. This is likely to put the brakes on US dollar strength and underpin a positive environment for EM assets for the remainder of the year in our view.