The Emerging Market Outlook 2018

Already it is looking like it could be an eventful year for emerging markets. Looking ahead, one particular global macroeconomic trend is the further tightening of central bank policy in developed markets, especially in the US. This has the potential to trigger outflows of capital from emerging markets. However, with many analysts predicting solid growth for emerging market economies this year, the probability of a large shift in capital flow dynamics remains low. In fact, capital inflows are still anticipated, but at a more gradual pace than 2017. Analysts are not expecting the magnitude of the rate hikes by the US Federal Reserve this year to be sufficient to turn the dynamics around for flows into these economies, citing stronger fundamentals compared to previous episodes of central bank tightening in the US.

When talking about emerging markets, one of the biggest questions surrounds China and about how the worlds’ second biggest economy will fare in 2018. Most commentators are predicting that China’s growth will slow this year to around 6.5%. China’s recent growth has been relatively reliant on credit creation; meaning that the amount of debt in Chinese economy will probably need to be better controlled going forward. Corporate debt is elevated at 170% of GDP; but of this, 110% relates to state owned enterprises. Moreover, the majority of this debt is funded internally using domestic savings. Control of the banking system and considerable influence over the real economy provides the authorities with levers to manage growth.

However, the authorities have acknowledged the need to address financial system risks, and part of the deceleration of the economy will be driven by policy tightening. The slowdown in Chinese growth is expected to be modest - declining from 6.8% to 6.5% this year. This should not place too much pressure on other emerging market economies, global growth, or commodity prices. However, it is something that will need to be carefully monitored for indications that policy measures are reigning in credit expansion significantly (by accident or design), and causing significant deceleration in the economy.

Indian growth, on the other hand, is anticipated to bounce back after experiencing a slowdown following the implementation of several landmark reforms. Data coming out of India is trending upwards, exhibiting further recovery. Many analysts are predicting growth above 7% this year, which will keep India among the highest growing countries on the planet. It is also probable that we will see some fiscal support for growth in advance of the 2019 elections.

Elsewhere, continued recovery in Brazil and Russia is expected. Record low inflation in Russia should to provide room for the central bank to continue to ease monetary policy, stimulating consumption and investment. In Brazil, lower interest rates have helped consumer and business confidence, widening the recovery further. The pace of the recovery in Brazil will depend largely on whether or not a credible pathway to fiscal stability can be established through the successful legislation of pension reform. With a presidential election scheduled for October, politics are likely to play an important role.

Even though returns for emerging market fixed income were relatively high in 2017, it has been predicted that such out-performance will continue this year but in a more modest, cumulative return fashion; with expected returns of between 6% and 7% for emerging market fixed income. Analysts are even more constructive on emerging market equities, with return predictions of around 15% for the year. As mentioned earlier, they expect that the positive backdrop is robust enough to withstand the headwinds that will come from the Federal Reserve tightening.

Currently, the market has only priced in three US rate hikes for this year, but there could well be four. This may be priced in very quickly if there is a high inflation report or strong communication from the Federal Open Market Committee. This could certainly surprise markets and lead to pressure on emerging markets. However, as previously discussed, the fundamental backdrop remains positive, and because current account deficits are smaller, reliance on capital flows are now more modest.

At the time of writing, the MSCI Emerging Markets index was flat year-to-date, while the MSCI China index is up 0.8%, and the MSCI Brazil index is one of the best performers for the year, jumping 9.5%.

Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.

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