Emerging Markets Insight

The single most important
price of an economy

Gerardo Rodriguez| Jeff Shen |Jan 29, 2019

Emerging market highlights

  • Financial markets appear to be entering a new phase after the big moves in rates and the Fed communication hiccup at the end of 2018.
  • EM equities will benefit from easier financial conditions particularly because exchange rates in many EM economies have weakened significantly in recent months.

Market overview

2018 was a disappointing year for EM equities, and for almost all financial assets, particularly after a strong year in 2017 where EM was up more than 35%. As we start 2019 and uncertainty remains elevated we believe that financial conditions have turned more supportive for EM equities to outperform again.

Some people blame geopolitical risks and in particular rising trade tensions, mainly with the US and China, as the main culprit for the poor performance of risky assets. Even after the resolution of NAFTA in a favorable way it is likely that ongoing disputes will continue for some time and markets have already incorporate the prospect of negotiations dragging along.

But the main problem that financial markets have faced has to do with the significant tightening of financial conditions due to the combo of Fed raising rates, credit spreads widening, the USD strengthening and equity markets falling. This has been exacerbated by the lack of recognition during the last Fed meeting in December of the need to be more flexible with the path of policy normalization, notwithstanding that inflation is projected to remain below the 2% target.

But all that appears to be changing at the start of 2019. The Fed Chair has finally recognized in a recent address to the American Economic Association that there may be a need for a pause in rate hikes and potentially a revision to the balance sheet reduction strategy. This has marked an inflexion point in financial markets potentially marking the end of the unusual behavior we saw recently where a strong economic backdrop has not delivered positive returns of financial assets.

This is particularly relevant for EM assets. Recent volatility has sent many EM currencies to multi-year low levels, particularly in countries like Russia, Mexico, Argentina and Turkey (see graph below). Currencies are the single most important price for any economy as it adjusts the relative value of all assets against the rest of the world in an instant manner and facilities macroeconomic rebalancing where it is needed. The combination of a stable growth outlook with depressed valuations of currencies provide a compelling case for EM assets to perform.

Real Effective Exchange Rates

North American Trade Risks

Source: Bloomberg and BIS, Dec 2018.

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China's onshore equity markets
China’s onshore equity market may benefit significantly in the coming years from the relatively fast pace of economic activity.
China's onshore equity markets

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