Righty tighty, lefty loosy

The asset class implications of divergence in emerging and developed market monetary policy

06 Apr 2018

Last year, a combination of recovering but still-below-potential growth and falling inflation allowed many emerging markets’ (EM) central banks to continue easing their monetary policy even as developed market (DM) central banks, led by the US Federal Reserve (Fed), were shifting into tightening mode. The deepest cuts were delivered in economies with high yielding government bonds such as Brazil, Colombia, Russia, Chile, Peru and Indonesia. India and South Africa central banks also cut their rates (see Figure 1).

 

Figure 1: Central bank policy rates

chart-1

Data as at March 2018. Note: DM average of Australia, Canada, Denmark, eurozone, Iceland, Japan, New Zealand, Norway, Sweden, UK and US. EM average of Brazil, Chile, China, Colombia, Czech Republic, Hungary, India, Indonesia, South Korea, Malaysia, Mexico, Poland, Romania, Russia, South Africa, Taiwan and Thailand. Sources: Haver, BNP Paribas Asset Management.

 

This year, the Fed’s dots are likely to shift sometime in mid-2018 to four hikes in the Fed funds rate for the year, and the ECB, while still well behind the Fed, is on track to taper quantitative easing in Q4 2018 and deliver its first rate increase in mid-2019. At the same time, China leader Xi Jinping is in a stronger position politically, allowing him to address more forcefully the country’s internal credit and debt-related imbalances. All of which appears to leave EM local currency debt and currencies (FX) more vulnerable compared to last year.

Add to that rising protectionism-related volatility, political uncertainty in developed economies – for example the ongoing Brexit negotiations, Italy’s difficulty in forming a government, and the US mid-term elections later in the year – and EM’s own dense political calendar, and the case for owning EM debt and FX is arguably looking less bright.

That said, from a macroeconomic perspective, EMs remain in a sweet spot of historically low and contained inflation and recovering growth momentum that is still catching up to the more mature DM growth cycle.

To be sure, with most of the EM easing cycle behind us, this year’s EM-DM monetary policy divergence is looking to be limited to high-yielding EMs. For example, so far this year we have seen Brazil, Colombia, Peru, Russia and South Africa all cutting policy rates further. The ongoing string of downside surprises on inflation, with traditionally large and volatile components of the CPI basket such as food and energy becoming more stable, could mean that EM central banks eventually lower their neutral policy rate estimates. This means that EM yields could continue to move lower on the expectations of such a policy shift.

On the flip side, low-yielding countries such as Mexico, the Czech Republic, Romania, South Korea and Malaysia, have all begun narrowing the rate differential via gentle and gradual tightening. In India, Thailand and Israel the central banks, while all still in waiting mode, have shown nascent signs of hawkish dissent on their monetary policy committees.

What are the factors that could prolong or interrupt this EM-DM monetary policy divergence?For the low-yielders with trade-surplus economies like South Korea, Taiwan and Thailand, increased noise on trade and currency wars from Trump’s administration could hit confidence and cause greater volatility, which could dent the growth momentum and thus delay the pace of tightening.

  • For the low-yielders with a high beta to eurozone growth (Poland, the Czech Republic, Hungary and Romania), where wage growth and labour markets appear to be at their tightest in years and output gaps are largely closed, central bank tolerance to rising inflation likely means a potential disorderly pick-up in inflation followed by aggressive tightening.
  • Domestic politics. Brazil and South Africa are the two most recent examples where corruption scandals have become a major driver of change, allowing the central bank to ease policy thanks to the tighter fiscal and pro-structural reforms stance. In Russia, on the other hand, where a tight fiscal stance was one of the major disinflationary drivers allowing the central bank to cut its policy rates, we see some risks for looser fiscal policies, thereby limiting the scope for further easing.
  • For the high-yielders and commodity exporters in Latin America, ample slack in the regional economies but less supportive base effects after the first quarter this year mean that inflation will rise, although only very gradually, allowing central banks either to cut rates further or stay on hold for longer.
  • From an external perspective, gradual and shallow monetary policy normalisation in DMs – as long as this is accompanied by higher DM growth with positive spill-overs into EM growth – should not be too disruptive for emerging market assets.
  • Better EM growth this year compared to 2017. Although sequentially we saw another deceleration in EM GDP growth in Q4 2017 from the preceding quarter, growth levels in H1 2017 were revised upwards. One should also keep in mind some purely domestic one-off factors weighing on EM growth in 2017:
    • in India, 2017 growth was disrupted by the introduction of the Goods and Service Tax reform (which should be positive for growth in the medium term);
    • in Russia, there were large swings in gas exports (strong in the first half year but weak in the second), some decline in nuclear fuel production in Q4 2017 and less arms procurement;
    • in South Africa, the leadership struggle weighed on business confidence and growth, but the new leadership is generally seen as a positive structural outcome for South Africa’s medium-term growth;
    • Mexico was hit by a powerful earthquake in Q3 2017;
    • in Chile, election uncertainty held up investment throughout 2017; and
    • finally, an oil refinery shutdown in Uruguay affected output in Q3 2017.

Put another way, had these factors not arisen, EM growth would likely have been stronger in 2017. Fading one-off disruptions and ongoing recovery in DM trend growth led by the EU and the US should be supportive for EM growth, and therefore selected local currency debt markets.