The plummeting dollar, crisis in the short-term money markets of developed nations and sluggish US consumer spending form a grim backdrop to the year ahead. But analysts are divided over how a mild US recession will affect the global economy and the vulnerability of emerging markets to shocks in the Western financial system.
Resilience
Merrill Lynch chides the consensus view that enforces the US role in driving global growth. “The global economy is not just a high-beta version of the US”. It argues domestic demand outside the US looks strong and will be largely immune to the global credit crunch in contrast to the “Anglo-Saxon household, which is the primary borrower on a global macro level”. Furthermore, a global liquidity strain prompting investor flight away from asset-backed securities is primarily a problem for the US since it accounts for more than three-quarters of annual issuance in that asset class.
But it also cites endogenous trends in emerging economies, in particular, abundant labour supply, current account surpluses and huge international reserves as well as accommodative monetary policies in Russia, China and the Middle East. As a result, next year will herald a new era of “non-US drivers of the global business cycle”.
But Merrill Lynch rejects the term decoupling as a misnomer and favours global rebalancing as a more accurate term describing global trends since “global rebalancing could take place even if a US slowdown had a substantial effect on non-US growth”. The bank believes that decoupling refers to the relative growth trends across countries but a more profound change is taking place - the primacy of domestic consumption in emerging sovereigns. “Rebalancing is a statement about the distribution of growth within countries.” This means investors should bank on export-orientated US companies outperforming as well as domestically orientated companies in emerging sovereigns.
By contrast, RBC cautions that “the increased integration of EM markets (trade and financial) into the global economy” will trigger a disorderly de-leveraging phase over the coming months that will affect asset classes globally. It predicts that this will spill over into the real economies of developing sovereigns in Q2-3 2008. In this scenario, it advises investors to prudently and actively differentiate EM asset classes. “Positive EM returns will be harder to come by and require a more disciplined portfolio approach with an active hedging strategy of buying protection and setting stop-losses as the market approaches key levels in the year to come.”
Latin America
Despite bullish headlines celebrating the region’s economic buoyancy, more stable inflation, improved fiscal accounts and debt management, sell-side analysts are concerned that the region’s business cycles are still significantly correlated with the US. Nevertheless, Merrill Lynch notes that deeper local markets and strong domestic consumption will make the region less vulnerable to changes in export performance and swings in the global credit cycle, predicting regional growth of 4.6% next year. “Stronger public and corporate balance sheets make LatAm less dependent on foreign savings and, hence, on global credit swings. Indeed, we think this will continue to support the case for more credits in the region graduating to investment grade starting late in 2008 (e.g. Peru, Brazil).”
But upward inflationary pressure next year is a risk to this favourable growth outlook and the bank calls for countries in the region to adopt more flexible exchange rates and market-friendly policies. “Higher inflation will impose more binding trade-offs to domestic policy-making, including more limits to expansionary fiscal policy and/or monetary easing.”
Michael Ganske, head of emerging markets research at Commerzbank, observes: “Brazil local markets (rates and FX) should continue to outperform on the bullish soft commodity outlook” and recommends inflation-linked bonds in the country. He also urges investors to target the long end of local yield curves in Chile and Mexico next year, since real-cash institutional investors will fuel demand for local market bonds.
Emerging Europe and the CIS
Alarm bells are ringing over the ballooning current account deficits, rising inflation and loose policy mix in the Baltics and south Eastern Europe. Ganske describes the region as the outlier in an otherwise positive story for emerging markets next year. He fears that investors are taking an overly benign view of the region, based on assumptions that EU convergence provide a sufficiently strong anchor.
But the region this year has been exposed to unsustainable capital flows, which have been “inflating asset bubbles, spurred excessive private sector borrowing, caused economic overheating and – in those cases where the exchange rate is more freely managed – overvalued the exchange rates.”
This leaves central and eastern European states vulnerable to continued turbulence in global financial markets, which could disrupt cross-border financial flows and “lead to the explosion of private debt.”
Analysts predict inflation is likely to overshoot central bank targets next year due to food price shocks, despite exchange rate appreciation and interest rate hikes in many cases. Accordingly, Ganske recommends holding “long EM FX basket including CZK, UAH, PLN” and inflation-linked bonds in Poland and Turkey.
HSBC believes the stellar performance of Turkish assets in 2007 is set to continue despite volatility in global markets and political tensions next year. Chief economist Philip Poole argues slower US growth will force the central bank in Turkey to cut interest rates still further to boost the economy, following the footsteps of the US Federal Reserve. In this scenario, Poole recommends stepping up exposure to equities: “The Turkish stock market – where valuations are still attractive, in our view – is in a very strong cyclical position.”
Credit Suisse takes a less sanguine view for Kazakhstan. The bank is seriously concerned that the retraction of foreign capital to fund the country’s oil-fuelled boom will destabilize the banking system. “This transition from a rapid expansion in the banking sector to a contraction will have a substantial adverse impact on the real economy.” Although the central bank has injected local currency and FX liquidity to local banks, this will not help domestic institutions improve asset quality or secure debt refinancing next year.
Credit Suisse concludes: “The combination of a weakening balance of payments, falling GDP growth, high inflation and the likely substantial rise in the banks’ NPLs will present serious policy challenges”. By contrast, Ganske at Commerzbank believes “big Kazakh bank names look attractive as risk premia are pricing systemic risk.”
High oil prices have propelled Russia’s growth over the last couple of years, but analysts predict its economy in 2008 will be driven more by domestic consumption and government spending, particularly in infrastructure. Ganske notes positively how Russia managed to ride out global volatility over the summer thanks to liquidity injections by the central bank.
What’s more, the country could act as an economic stabilizing force in the region with its abundant liquidity: “Russia could become a regional driver of growth as it sucks in capital goods from Western Europe.” However, Credit Suisse is less bullish, fearing that Vladimir Putin’s mission to maintain a stranglehold on power will spark a battle between Kremlin camps jockeying for power, and so “raises the risk of a negative surprise for investors.”
Middle East and Africa
The biggest challenge is not easing oil prices but the sustainability of the dollar peg of Gulf Co-operation Council (GCC) countries. The arrangement forces central banks with fixed exchange rates to follow the US monetary cycle, which is currently in a loosening phase – this has already sparked double-digit inflation in several Gulf states. At present, there is no consensus among GCC authorities over how to mitigate this unwanted monetary stimulus and plans for a monetary union by 2010 are in disarray. Marios Maratheftis, chief MENA economist at Standard Chartered, calls for immediate reforms, warning: “in the presence of a USD peg, the economy will be acting as the shock absorber, not the exchange rate.”
Speculators are already selling the UAE dirham in the forward exchange rate market at stronger than its pegged rate, banking on the central bank pegging the currency to a basket. And Ganske recommends: “Hold long GCC currencies to benefit from positive probability of revaluation.”
Yield-hungry investors with a strong risk appetite helped to drive Africa’s economic rebound this year, with fiscal performance aided by debt relief and strong commodity prices. The concern now is that the continent could be vulnerable to the global re-pricing of risk and de-leveraging. But Razia Khan, head of African research at Standard Chartered, argues that Africa is not threatened by an imminent reversal of portfolio inflows since “the small size and relative illiquidity of African markets have acted as a natural limit on the extent of offshore participation, serving to reinforce the degree of Africa's non-correlation with the rest of the world.” Furthermore, foreign investors have focused on less risky government debt markets, where supply is scarce, and investors have a hold-to-maturity attitude due to the absence of a liquid secondary market.
“Even for equity investors, the lack of depth in both equity and FX markets means that they face the risk of moving the price against themselves, if they try to sell significant amounts of their holdings at any one time.” Lack of liquidity means Africa will remain largely immune to current financial market shocks, Khan explains. The bank predicts that ambitious project financing plans by local banks in Nigeria and Chinese investment in the continent could hit a record next year.
Asia
The year-on-year stellar growth story in the continent will be challenged next year by the global credit crunch as well as high inflation, resource shortages, unsustainable dollar-centred foreign exchange regimes and immature domestic consumption, according to sell-side analysts. “As resource constraints approach, prices of goods and assets could behave in a “non-linear” manner. We expect Asian inflation to rise, but the risk is that it will explode. We expect currencies to appreciate, but the risk is that they will surge,” Credit Suisse explains.
Inflation, abundant liquidity and asset price bubbles may prompt Asian central banks next year to interfere with market mechanisms and deal with “FX inflows through controls on capital inflows (such as restrictions on foreign borrowing) or quantitative measures to reduce domestic liquidity (such as increases in the required reserve ratio).” Given these risks, the bank argues investors should be more prudent and consider re-allocating money away from stocks to Asian FX.
Nicholas Kwan, head of Asia research at Standard Chartered, calls upon Asian central banks to use currency appreciation to fight inflation and override concerns over export competitiveness. “However, without a regional coordination framework, Asian central banks will face increasing challenges in balancing their monetary and exchange rate policies in 2008, especially if the USD were to weaken sharply and the pressure of export competition escalate,” he concludes.