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Emerging markets popularity could ease – but not as a result of dollar action

The recent rebound in the performance of emerging markets has renewed the interest of international investors. Although the threat of an increasingly strong dollar has subsided, and many currencies have stabilised, there remain deep concerns over the future growth of these markets, which could prompt a reversal of fortunes.

May 6, 2016 // 9:02AM

The increasing interest of large asset managers in emerging market assets lately is clear. A number of factors have contributed to a renewed bullish attitude towards the asset class. However, threats to the stability of some of these economies still exist, which could put a quick end to the recent emerging market rally.

Dovish signals from the US Federal reserve have provided a lifeline for emerging markets. A slower rise in the dollar’s strength provides developing economies with more breathing room, especially in countries where the sovereign or corporates are highly leveraged in US dollar denominated debt.

Win Thin, in a recent note from New York-based Brown Brothers Harriman noted that many emerging market currencies have recouped their losses since the end of last year, when a US rate rise, combined with the poor performance of emerging markets across the world, saw the performance of currencies slump.

The performance of emerging market currencies is not only affected by the Fed’s policy decisions. Action is being taken in many emerging markets to stabilise their respective currencies, which has then had knock on effects in other areas of the economy.

Jan Dehn, in a research note from Ashmore, noted that in Argentina the central bank will aim to lower inflation from 35% to 5% by 2019. This will help the credibility of the country’s peso, which could also lead to a reopening of the domestic bond market. The country is currently cultivating its status as the darling of emerging markets.

Russia’s central bank is poised to lower interest after the rouble steadied on the relative stability of oil prices and in Brazil inflation has been improving.

Dehn noted that Colombia’s central bank has increased interest rates by 50bp to 7%, which has strengthened the currency and will benefit long term investors in the country.

As well as the recent boost to emerging markets provided by the currency rebounds, emerging markets are again in favour on action to improve their deficits.

Mexico’s trade balance has recorded a surplus of US$155mn, and the country’s fiscal deficit for Q1 this financial year is one third lower than last year, at MXN61.6bn. Reforms in Mexico have meant that the country will likely be able to sustain a faster growth rate without adversely suffering from inflation.

Despite Mexico’s ability to sustain its rate of growth, the fastest growing countries will be located in Asia. Deutsche Bank’s Markus Jaeger explained that the weakening of structural factors and a lack of reform are underpinning growth in many emerging markets.

He noted that Asian emerging markets, excluding China, are performing better than their peers. Per capita income levels favour Indonesia and India where they remain low, which allows for growth.

Many emerging markets, excluding India and Indonesia are facing a middle income trap, or stagnating growth. Russia and China belong to this group, and Brazil, Mexico and Turkey will also be affected as they reach the second, higher income threshold.

In Russia’s case, the commodity boom had masked the decline in Russia’s underlying growth potential, Jaeger added.

Demographics factor heavily into emerging market concerns, especially regarding growth. In India, Mexico and Indonesia, dependency ratios are falling and the working age population is rising, contributing to growth. However, in China and Russia the opposite is true, so their fundamentals are weaker. Brazil and Turkey will also soon experience this problem according to Jaeger.

Win Thin noted that the emerging market rebound will continue to extend its rally after January and February lows, and as a result, investors will continue to remain bullish. However, he added that developing economies will meet turbulence later in the year.

It appears the volatility emerging markets will meet later this year will vary according to each developing economy, but could be mitigated in some contexts. Reforms enhancing productivity would favour the growth potential of all emerging markets, but structural factors will favour India and Indonesia in the near term according to analysts.

It is unlikely, though, that rising US interest rates will weigh on emerging markets in the near future. An informal ‘Dollar Accord’ has been struck amongst G20 countries, which aims to limit the damage to global growth that the dollar can cause, which reverberates with previous signals that the Fed rate rises could be much more cautious in the future.

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