The Macro Report | June 2017

The new consensus trade

Emerging markets have soared so far this year. While there is much to like about the asset class against the backdrop of weak global interest rates, there is much that argues for a healthy dose of caution.

The global backdrop has encouraged large capital flows into emerging markets (EM) so far this year, across equities, local bonds, and hard-currency bonds. When U.S. rates rise, on the expectation — or the hope — that the Fed will hike more aggressively, we see a wobble in this flow, but as rates ease, the flows resume. Of course, the trend in U.S. rates this year has been down, which has augmented the strength of investor interest in EM.

U.S. policy inaction has helped

In the past six months, fears about Trumponomics, protectionism, and border walls harmed capital flows to EM, especially to Mexico, but these fears have also tended to ease as the Trump administration has implemented virtually nothing on these fronts. This is not to say these issues have disappeared. The Trump administration could still empower the U.S. nationalist faction, withdraw from NAFTA, and impose trade restrictions, but this does not seem to be the way the wind is blowing.

Local turmoil? No problem

Interestingly, domestic political factors have been strikingly negative across EM so far this year. The South Korean president was removed from office. Turkey held a referendum on a constitutional change that many observers see as a sign marking Turkey’s illiberal future. In South Africa, President Jacob Zuma is under intense political pressure for deeply embedded corruption. And speaking of corruption, Brazilian President Michel Temer, who took office last year following the impeachment of Dilma Rousseff, has himself become embroiled in a corruption scandal. These developments matter for the economic outlook for these countries in many ways, but none of them appear to have done much to deter investors.

Domestic political factors have been strikingly negative across EM so far this year, but none of these developments have done much to deter investors.

China slows again

And then there is China. As our Nowcast for China shows, growth has slipped. Policymakers still seem to be in tightening mode, although they are also in heavy intervention mode. In May, China changed the way it manages the yuan’s exchange rate, introducing some discretion into the way the daily rate is calculated. The result is likely to be a partial re-anchoring of the yuan to the dollar, giving the authorities the ability to minimize tension with the United States.

China downgrade

The other interesting development in China was Moody’s credit downgrade. China had been rated Aa3 by Moody’s since late 2010, but in late May the rating was lowered to A1, which is where it had been from 2007 to 2010. In and of itself, this doesn’t mean too much, since it does not push China across the investment-grade barrier that matters for index inclusion and investor behavior. What was interesting, however, was the rationale Moody’s gave for the downgrade. Citing their “expectation that China’s financial strength will erode” and that “economy-wide leverage will increase,” Moody’s articulated something we have long felt: China’s debt dynamics do not look appealing.

Indeed, total debt is now 250% of GDP, which is the kind of level associated with countries that enjoy much higher income levels. Moreover, the policy mix in China means the actual and contingent liabilities of the sovereign are rising rapidly. While we believe China has the resources to deal with this and we do not think a crisis is imminent, the basic fact is that China is exhausting its financial resources at an alarming rate. At some point, we think this will cause a major problem — not just for China, but potentially for all of EM.

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