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Emerging markets stay sheltered from EU storm

This article is part of
Investing in Asia - August 2016

Emerging markets stay sheltered from EU storm

The outcome of the UK’s EU referendum adds uncertainty to the economic outlook and complicates the global political framework.

However, we believe that the consequences of Brexit will be mainly felt in developed markets – in Europe in particular through deterioration in confidence and investments – while emerging markets appear to remain more sheltered.

When looking at global growth expectations for the near future, the relevant role of emerging markets in the global economy continues to be apparent. Even with major country differences, overall, emerging markets appear to be more resilient to external variables.

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Some positive factors – including some stabilisation in commodity prices, the smoothness in the US Federal Reserve normalisation of interest rates and monetary easing coming from Europe and Japan – have supported emerging market currencies and bonds, and favoured the adjustment processes of these economies.

In Asia, tail risks of a Chinese hard landing have eased and it remains one of the least vulnerable emerging countries, according to a number of economic indicators. Relatively speaking, the country has the advantages of a stable political system, a resilient external balance sheet with current account surpluses, and there is still potential for monetary and fiscal stimulus.

Capital outflows seem under control, even if they remain a risk factor to monitor, and the property sector stabilisation continues. The reform process continues to broaden into areas of the economy traditionally less efficient, such as the financial sector and state-owned enterprises.

The impact of Brexit on China might not be too negative. In spite of some possible side-effects coming from the trade relationship with Europe, one of China’s largest trading partners, Brexit may help ease capital outflow pressures due to the increased uncertainty overseas.

Besides, the weaker political positions of the EU and UK might help improve China’s bargaining power in trade and investment deals.

While China continues to play the most relevant role in the emerging markets space, other countries, such as India, continue to increase their relevance thanks to less vulnerable economies.

India stands out as one of the few attractive opportunities with largely endogenous drivers. Inflation is under control, the current account position has moved from a negative to a positive balance, and a strong effort on fiscal consolidation has been made.

As India is a relatively protected economy, limited damage could be expected from a further slowing in global trade induced by the UK’s vote to leave the EU.

In this environment, emerging market bonds will continue to be sustained by the dovish Fed stance as well as the search for yields. Selection will be key as different economies are at different stages of their development process and face different challenges.