While some emerging-market assets have started to rebound, their economies remain vulnerable to a slowdown in China and rising global interest rates.

Emerging markets’ manufacturing purchasing managers index (PMI) edged up in December, signaling that conditions in manufacturing sectors are much healthier than a few months ago. Indonesia and Hungary, in particular, accelerated, while Mexico, Brazil, and Russia stabilized. But the manufacturing sector in China and the more advanced Asian economies weakened. Emerging-market assets have started to rally, currencies have stabilized, and dollar debt markets are looking better. Still, we need more clarity on global developments before turning bullish.

China’s cooling economy

There are many headwinds facing China’s economy, and the trade war with the United States is one of them. Still, the government has the tools and the determination to keep overall growth at its target. China is not a major source of risk for the global economy as evidenced by weaker PMI data and the central bank cutting the reserve requirement ratios for banks. The China–U.S. trade war, which creates some economic problems, also creates policy options. China can calibrate what kind of concessions they are prepared to offer with an eye on the domestic economy.

However, as the economy grows and becomes more sophisticated, the policy challenge will mount, and the chance of a policy mistake will rise. The Chinese authorities are used to having a great deal of control over the economy and being able to fine-tune economic outcomes as closely as they fine-tune political outcomes. Their ability to do this is shrinking over time, and more real economic volatility is likely as a result. But this does not mean that China will be the source of the next global recession. For the time being, we do not see this as a major risk.

Risks in emerging markets

Emerging markets are a small piece of the puzzle. It’s the tail, not the dog. Like other risky assets, emerging markets do well in a Goldilocks environment. But they are different from other risky assets because they are more exposed to dollar movements. Developing markets thrive when the dollar weakens or holds steady, interest rates fall or remain low, and there is decent economic growth. These markets do badly when the dollar and interest rates rise and growth slips.

China's growth trends lower

In the current global environment, we expect emerging markets to remain a bit vulnerable.

In the current global environment, we expect emerging markets to remain a bit vulnerable. If our central forecast proves to be correct, emerging markets will do quite well; we expect decent global growth and the Fed to be on hold. The dollar is always a bit of a mystery, but the chances of a sharp dollar appreciation do not seem worryingly large. The problem is how we get there from here. With markets still unsure about recession risks and with lingering uncertainty over exactly how the Fed is looking at the year, assets remain somewhat vulnerable. We expect to turn bullish on emerging-market assets at some point, but not just yet.

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Forecasting 2019 means interpreting the interactions between economic growth, interest rates, and risky assets.