Under the bonnet: Key themes for emerging markets this year

Dollar strength and plunging oil will have a big impact

MUCH of the growth the global economy has seen since the financial crisis has emanated from emerging markets.

But many analysts expect this narrative to change in 2015, with growth momentum shifting to developed markets like the US. Late last year, Fitch revised down its forecasts for global growth in 2015, noting that emerging market economies face larger and more persistent weaknesses than previously expected.

But the ratings agency also highlighted the importance of disaggregation in understanding what will happen to emerging markets this year. Countries like India are likely to do rather well in 2015, owing to economic reforms and a positive business environment. Brazil, meanwhile, is set for another challenging year, with growth of just 1 per cent.

Commodities are likely to be a key theme for developing markets. The blow dealt by Western sanctions, alongside the plummeting oil price (Brent crude hit a six-year low yesterday), will see Russia fall into recession in 2015, Fitch said. Other oil producing exporters, like Nigeria and Venezuela, will continue to feel the force of the oil price slump. Commodity exporters more widely are also feeling the heat: the Goldman Sachs Commodity Index is down almost 35 per cent over the past year, promising potentially severe economic and political challenges through 2015.

Panmure Gordon’s David Buik says he’d be seriously inclined to give the majority of emerging markets a wide berth this year. But where, if anywhere, should you be looking?

Falling oil prices are being underlined by a surging dollar. Brenda Kelly of IG points out that the currency’s uptrend will likely see the Federal Reserve laying the ground for its exit strategy from QE, as it also weighs up timing for its first interest rate increase in nine years. This, she says, will see weaknesses materialise in some emerging economies, as domestic currencies depreciate. Although increasingly expensive exports from the US could pose a problem, she says, it will mean “more attractive exports for many developing countries.”

But Forex.com’s Matt Weller, writing in the firm’s global outlook for 2015, isn’t so upbeat. Keeping on top of whether falling commodity prices are hurting or benefitting an economy means traders should look to “closely monitor each country’s terms of trade, or the price ratio between a country’s exports and imports,” he recommends.

Of course, for commodity importers – like Hungary, Poland, South Korea and the Philippines – there could be an improvement in current accounts, Peter Marber of Loomis, Sayles told Barron’s. And cheap valuations, especially in light of the dollar’s recent surge, are playing to emerging markets’ advantage, he says – the MSCI Emerging Market Index is trading at about 10.5 times forward earnings, below its 10-year average of 10.9.

But whichever way you look at it, a storming dollar means emerging market currencies are in for a “painful plunge” this year, says Weller. As we moved into 2015, the JP Morgan Emerging Market Currency index, which measures the strength of a range of developing country exchange rates against the dollar, fell to its lowest level since it was created in 2000 (see graph).

And currency depreciation isn’t the only challenge certain emerging economies face. “Countries with a high level of debt denominated in US dollars may also feel the brunt of the strong dollar,” says Kelly. Government revenue, she warns, may not be enough to stave off growth risks and higher borrowing costs. “Emerging market balance sheets are largely in the red, with budget deficits expanding to levels not seen for a decade”. The likes of Venezuela, Ukraine and Argentina are already on the at risk list when it comes to default. Meanwhile, Buik highlights Brazil’s enormous reliance on the dollar as a firm reason to keep foreign investors away for at least a few months this year.

City Index’s Ashraf Laidi points out that developing markets’ risk from dollar appreciation could be further exacerbated if borrowers’ rising currency costs are combined by an increase in US bond yields.

But despite dollar-generated negativity, some markets still retain appeal. Mexico, says Weller, is “taking a cue from its northern neighbour,” with its economy and currency expected to hold up “relatively well” this year. Despite being a net exporter of oil, major structural reforms along with projected strong growth should allow its central bank to hike interest rates later this year.

And other economies are also showing resilience. Laidi points out that India appears to be the biggest Bric beneficiary of tumbling oil prices, given that it’s the most dependent on energy imports. Its Sensex stock index added 33 per cent last year because, as Buik puts it, it now has a government that is providing stability “and respected economic housekeeping.”

Laidi warns that the perfect storm for emerging markets this year will be a gaining dollar paired with broadening weakness in the Chinese economy. But some aren’t concerned by China’s less feverish rate of expansion (this year, it’s expected to grow by 7.3 per cent, down from 7.5 per cent). Writing for City A.M. last week, Nick Beecroft of Saxo Capital Markets said that there is a diminishing risk of a hard landing. Authorities armed with an adequate supply of ammunition to deal with slowing growth mean that we should be sanguine about its slowdown. Buik adds that, although China is not attractive at present, “in a few months’ time, it may prove irresistible to investors.”