Emerging Markets 2016 Outlook - EM Cornered

EM Cornered
EM economies are growing at their slowest pace in well over a decade (outside of the global financial crisis) and the pickup that we expect next year is mainly a reflection of fading recessions in Brazil and Russia. The scope for looser policies to boost growth is generally limited, however, especially in Latin America. That leaves currency weakness as the only adjustment mechanism in play in many cases, albeit an ineffective one where supply bottlenecks and excess leverage remain in place. Ultimately, more vigorous structural reforms will be needed. Some countries, including China, India, Indonesia, and Mexico, have embarked upon this path. Others have been slow to follow, though this will slowly change as growth remains low and the case for reform becomes more compelling. Among the more immediate risks to the outlook, we are optimistic that the re-balancing of China's economy will remain a relatively smooth and benign process, though even this has already had profound implications for EM commodity producers. The other main source of stress resides in overstretched private balance sheets in some parts of EM, which may further depress growth as these excesses are unwound. By contrast, though with some exceptions, we think sovereign balance sheets are in relatively good shape and that buffers against external shocks are adequate.

FX in 2016:
Incomplete Adjustment EM FX continues to play the role of adjustment valve for concerns ranging from growth to commodities to China, and expectations of policy normalization in the US. We have come a long way in 2015, but this process is still incomplete. However, there is scope for outperformance of selective currencies, particularly versus the euro, where growth is solid, carry is supportive, and exposure to external risks is low and where a backstop is provided by valuations or central bank policy. China is arguably the most critical tail risk for EM FX in 2016, with commodity exporters and countries with large direct trade links most exposed.

Rates in 2016:
Slippery Slope Upwards We believe that EM local fixed income repeats last year’s unappealing results and likely underperforms in 2016. Besides the effects of a Fed lift-off, inflationary pressures and credit deterioration should continue to weigh on duration exposure across the regions. That said we expect cross-country/region heterogeneity to result in different yield/curve dynamics under our benchmark scenario. In a nutshell, we expect low-yielders to bear-flatten and high yielders to bear-steepen. In this divided world, front ends will likely experience a tug-of-war between rising inflation pressures and lackluster activity while backends should reflect fiscal/idiosyncratic risks. Altogether we believe that diversification will reign, with the odds of a generalized unraveling in EM being considerably smaller vs. stressed years.

Sovereign Credit in 2016:
Seeking Alpha amid Diminishing Returns A moderate pick-up in growth and commodity prices are unlikely to lead to a meaningful improvement in EM credit fundamentals. The external environment remains challenging, and technical conditions are supportive with likely continued outflows and the largest net supplies in years. The outperformance in 2015 leaves a very thin cushion against these headwinds. We expect diminished total returns in the benchmark in 2016, as moderately higher credit spreads and UST yields partially offset the return from carry. However, as idiosyncratic factors may create very divergent performances once again, we recommend investors focus on gaining alpha via credit differentiation.

EM Debt:
Raising the Funding Bar As the Fed seems finally on its way to start normalization, EM funding will be under tighter scrutiny in the years ahead. Demand for EM debt is on a declining trend as portfolio flows shrink, while both EM sovereign and corporate funding needs are on the rise on wider deficits and rising leverage amid eroding cash buffers. Nevertheless, given light maturities and sufficient cash buffers, liquidity is generally not a problem in 2016, apart from a couple of pressure points such as Venezuela in terms of sovereigns, as well as Petrobras in terms of corporates.

Asia’s Triple Troubles
Between aging, rising debt, and stagnant trade, many Asian economies face major headwinds to growth and prosperity in the coming years. There are enough savings and safeguards in place in the region to mitigate risks of an outright crisis owing to these headwinds; a more likely scenario however is a gradual erosion of potential GDP growth rate, worsening of public finances, and a general decline in sentiments about the region’s prospects.

China’s Trade Gravity
We explore various aspects of trade linkages between China and the rest of the world. After adjusting for processing trade, we estimate that China maintains the upper hand with trade share in central Asia, Oceania, a large part of Africa and Middle East, Brazil, Chile, and Russia. But the US influence is also visible in every continent. Interestingly, China and the US are split even in East Asia.

Potential of a United Korea
A gradual economic union with its Northern neighbor would be a boon for the South Korean industry, giving it access to a cheap, organized, literate workforce. Given their vast economic differences, Korea may not pursue the German model, which could result in a migration crisis and push the cost of unification prohibitively high. What is clear, however, is that North Korea has the option of using its labor force as a bargaining chip, not the nuclear weapons program, which has mutated from being a source of monetary reward and security insurance into an existential threat. (Read Full Report [Singapore Highlights on Pg 85])

Source : CIMB Research