The good news first: the general sentiment at the traditional Spring IMF/World Bank meeting in Washington was better than we expected. This may surprise you just as much as us given that adverse economic and political news flow has been dominating recent headlines. So what was the reason for the good mood (assuming it wasn’t just the end of an exceptionally cold winter)?
First, global rates look well anchored at current levels. This is important because financials markets still remain haunted by the spectre of a sharp hike in US Treasury rates, which could potentially cause havoc to the global economy. However, European Central Bank (ECB) quantitative easing coupled with the US Federal Reserves’ (Fed) apparently determined to engineer a very gradual adjustment of monetary policy have mitigated such concerns. This is particularly positive for emerging markets as they can continue to refinance at low relatively low rates.
Second, emerging markets turned out to be more resilient to materially lower commodity prices, especially for oil and iron ore. We are not suggesting that emerging markets are not affected by lower commodity prices. In fact, the impact has been very visible in some countries, in particular in major oil producers such as Russia, Brazil or Nigeria. Nevertheless, thus far they have coped better with the commodity headwinds than in the past for a variety of reasons. In addition, commodity prices seem close to bottom.
As a result, the overall capital flow picture to emerging markets also turned out better than expected. One of the main concerns at the beginning of this year was that EM debt and equity would suffer significant capital outflows across the board. In reality, EM debt managed to attract inflows (our CIB research estimates USD 11.3bn by mid-April) and the picture for global EM equity strategies seems to be turning around, which helps mitigate fundamental concerns surrounding emerging markets ability to finance current account deficits.
However, this would not be a blog about emerging markets without caveats. Perhaps the most important from our perspective is about Brazil. Whilst the efforts of finance minister Joaquim Levy to restore discipline and credibility to fiscal policy were acknowledged, the concern was that maintaining the fiscal momentum would be increasingly difficult as the recession deepened. Brazil’s sovereign rating looked safe for now, but the possibility of a downgrade could not be ruled out.
The view on Greece has turned from cautiously constructive to indifferent, which is perhaps the most worrying. As a result, default has become a realistic scenario, in particular as the IMF lacks the mechanism to support Greece beyond the existing programmes. However, some observers warned that the potential contagion from default should not be underestimated.
Another country in the headlines for the wrong reasons is Ukraine. The IMF demands that it restructures its debt and that investors accept a haircut in order to provide additional financing. However, it appears that some creditors are not prepared to accept that, which implies that Ukraine might be heading for default. This seems all the more deplorable as the government appears to be taking the right steps. One should never rule out last-minute compromise but time is running out. If Ukraine fails to agree the re-structuring with its creditors by the end of May as demanded by the IMF it might face default.
But let’s end this blog on a positive note. Neither China nor Russia featured high on the “to worry list”. The latter because of deleveraging and financial buffers and the former because the economy is slowing but not derailing, whilst tail risks (eg property, private sector debt) seemed manageable.
In conclusion, it would be certainly overly optimistic to assume that all is well in emerging markets and some of the risks, in particular those surrounding Brazil, could still lead to potentially painful market dislocations. Nevertheless, policy makers felt more comfortable with the overall willingness and ability to cope with risks than a few months ago, lending support to our view that risk management and differentiation remain key to investing in emerging markets.