Our world is changing: we now expect Fed Funds to peak at 4.75% in Q2-06 then fall to 4.00% in Q4; the ECB to tighten to 2.50% by Q2-06; the BoJ to stay on hold. Tightening should stabilise world growth by capping real estate,
consumption and inflation. G3 yield curves should stay flattish, but commodity prices buoyant, supporting EM fiscal and external accounts. We still advise staying invested, but curbing interest rate duration in USD and EUR, and reducing USD funding in EM.
The world will gear down as Central Banks tighten up in synchronicity. We don't see inflation surging, but expect the US, UK and China to slow in 2006. But we do not expect tighter money to impart dramatic economic drag in EM, even if it boosts EM asset price volatility. Slower growth in the "bubbly" economies will curb G7 inflation, while recovery in commodity/energy-importing EU and Japan would take up some slack, supporting EM export prices.
External debt is set to bear the brunt of higher Fed/ECB rates. But EM currencies should be supported by rebalanced global growth thanks to trade surpluses. Risk scenarios - deflation or accelerating inflation - cannot be ignored:
1, Sharp falls in US real estate or other asset prices precipitate wrenching global adjustment;
2, Accelerating core inflation due to energy shocks, requires sharper tightening. EM fallout would be limited: asset prices might plunge, but strong external positions and high reserves would shield systemic credit quality. EM would recover fast, as sharp monetary easing would be needed to alleviate the G10 credit crunch.
Global macro and EM political themes complicate the tea leaf reading but BoP/fiscal surpluses make it no less compelling. EM fundamentals may suffer if trade or capital flows fall on rate hikes, or if EM politics goes too far south. But that's where high reserves come in. Brazil's political noise is rising again after a brief respite. We expect no policy
change. Event risk has been sharply cut by the C/A surplus and paydown of USD-linked debt; FX reserves can now be used to smooth FX vol, rather than finance corporate or bank FX exposures. Mexico's politics remain as opaque,
and reform as mired as ever, but macro policy is securely anchored. Argentina now has a chance to grasp the nettle of stability-oriented macro policy with elections out of the way until 2007. Ukraine's political economy must be
watched, but the steel privatisation is big enough to mitigate credit risk even if a chunk is spent outright. Russia may spend more of its oil windfall, but will still pay down public debt like gangbusters, even as succession struggles get underway. Turkey focal points should be fewer, now that IMF talks are done and EU talks are underway; the next key event may be the CB succession in March 2006.