Our big theme for 2016 is retreat, regroup, rebound.
We expected emerging markets to come under pressure early in the year, only for them to regroup and rebound. And sure enough, this is what happened.
As for the second half of the year? Get ready for retreat, regroup and rebound part two.
Brexit, the UK vote to exit the European Union (EU), has sparked another round of risk aversion. Think again if you were hoping for a quiet summer.
Political uncertainty in the UK could discourage foreign investors, which leaves the pound looking vulnerable
The bigger impact will be on the UK itself. The UK runs a massive current account deficit of more than 5 per cent of GDP, making it dependent on foreign capital inflows. It is one thing to enjoy foreign inflows, and quite another to be dependent on them. The problem is that political uncertainty in the UK could discourage foreign investors, which leaves the pound looking vulnerable.
There are also risks for the EU. Voices of dissent could become louder. Focus will likely turn to Italy’s constitutional referendum in October this year.
Impact on emerging markets is mostly indirect
What is the impact of Brexit for the rest of the world? For emerging markets, it is mostly indirect. Lower growth in the UK, and particularly in the euro area, will probably lead to slower trade growth. This creates downside risks for growth for exporters. And if confidence deteriorates further, other economies may begin to be affected.
The US dollar is an important channel of Brexit crisis transmission. The dollar tends to appreciate at times of elevated risk aversion and/or at times when the Federal Reserve (Fed) is hiking. Lower risk appetite should keep the dollar supported. But if, as we expect, the Fed does not hike interest rates further, then a US dollar rally could lose momentum. This should keep the pressure on the Chinese yuan (CNY), and emerging markets in general, manageable.
The main global economic risk, however, is that growth was low to begin with. Sluggish growth makes it harder for the world economy to deal with shocks.
Expect Asia to rebound
These risks explain why we expect some retreat. But at the same time we expect emerging markets to regroup and rebound, especially in Asia.
Our somewhat optimistic outlook on emerging markets stems from our three big non-consensus calls, all of which are playing out well.
First, market consensus is gradually converging with our view of no further Fed rate hikes in 2016, which we have held since last December. Back then the consensus was five hikes in 2016, but we took the view that the Fed would not raise rates much further, and that its next move would to be a rate cut. If our Fed call is correct, this would be positive for liquidity and risk appetite for emerging markets. It might also provide the freedom for emerging markets to cut their own interest rates further to boost growth.
Brexit is mainly a UK and European problem
Second, we maintain that China will not experience a hard landing, and that the CNY will not see a substantial one-off devaluation. While we acknowledge the risks of high leverage in China, we still hold a constructive view on the country. Developments in China can have significant spillover into market sentiment towards emerging markets.
Third, we hold onto our positive outlook on oil prices. Risk aversion and a rebound in the value of the US dollar will probably keep oil prices under pressure. But we expect these pressures to be short-lived, as demand and supply dynamics should eventually push oil prices higher. In our view, non-OPEC supply will have to fall, as producers cannot keep selling at a loss.
Brexit is a shock, and global growth is not strong enough for us to ignore such a shock. But Brexit is mainly a UK and European problem, albeit with broader implications. Our expectations for fundamentals and policy suggest that sentiment towards emerging markets should improve quickly. And after the initial retreat on lower risk appetite, we will look once again for a rebound.