On 8 September the MSCI Emerging Markets index was up 14.18 per cent since the 1 January, outpacing the 9.76 per cent gain seen in the developed market-focused MSCI World index as investors returned to the asset class due to attractive valuations and improving outlooks.
But as the graph below shows, emerging markets (EMs) have since handed back the year’s gains. The MSCI Emerging Markets is now down 2.18 per cent since the start of the year while the MSCI World has risen 6.94 per cent.
Performance of indices over year to date
Source: FE Analytics
With issues such as slowing growth in China, the prospect of tighter monetary policy in the US, the plunging oil price and a stronger US dollar, macroeconomic forecasting consultancy Capital Economics has looked at the questions emerging market investors need to ask as we move into 2015.
Will the emerging world fall into crisis in 2015?
Capital Economics says emerging markets will “probably not” enter another crisis next year but adds that some countries will run into trouble - mainly because of the recent tumble in the price of oil and the strength of the dollar.
“Several EMs, notably Russia, will be hurt by lower oil prices, and the rise in the dollar will put pressure on those EMs, such as Turkey, that have increased external debt over the past couple of years,” the consultancy’s analysts said.
“But most will benefit from lower oil prices and, with one or two notable exceptions, foreign currency debts are much lower than in the past. Some EMs will run into trouble but fears of a widespread crisis in the emerging world are overdone.”
When it comes to the oil price, Venezuela’s ongoing balance of payments crisis makes it the most vulnerable to continued declines while Russia's economy would also be hit severely. But the Gulf states’ strong balance sheets mean they can weather falling oil revenues, while the likes to Turkey, India and South Africa will find their “worrisome” current account deficits start to ease.
A stronger dollar will create strain in the balance sheets of emerging markets that borrow in foreign currencies. However, most have tended to borrow in local currencies since the crises of the 1980s and 1990s, meaning the problem may be less severe than feared.
What other risks could EM investors be overlooking?
While investors have focused on oil’s slump and the strengthening dollar, Capital Economics reminds them that there are other risks facing the asset class - and highlights the rapid build-up in credit as something they should keep a close of eye on.
It says the rapid expansion in private-sector lending in EMs over recent years could be worrying, noting that no emerging market where the private sector credit-to-GDP ratio rise by more than 30 percentage points within a decade has managed to avoid a banking crisis. China, Brazil, Turkey and Thailand have all seen recent jumps in private sector lending.
“To be clear, this doesn’t mean that banking crises in these countries are inevitable. And there are reasons to think that a crisis now wouldn’t be as painful as in previous EM banking crises, not least because much of the recent surge in lending has taken place in local currency, not foreign currency,” the analysts said.
“Nonetheless, it does seem likely that loans will start to sour in greater numbers in these countries, which will constrain credit growth in the years ahead.”
Will 2015 be the year that EM growth breaks above 5 per cent?
While investors got used to emerging market economic growth of between 6 and 8 per cent before the financial crisis, this has since slowed to around 4.5 per cent over the past three years.
Capital Economics says much of this is down to the “synchronised structural downturn” in the BRIC powerhouses of Brazil, Russia, India and China. Aside from China, none of these have made significant progress in the supply side reforms needed to revitalise growth.
Meanwhile, emerging markets that rely on commodity exports to support their growth are in for a tough time given the fall in prices here - especially if oil prices remain at their depressed levels after their recent plunge.
The group added: “As a result, hopes of a significant rebound in EM growth are likely to be disappointed, and we expect another year of 4.5 per cent growth. But while the ‘new normal’ for EM growth is going to be much weaker than in the past decade, there may be one or two success stories in some of the smaller emerging market economies next year.”
Which EM central banks could spring a surprise in 2015?
Recent weeks have seen policymakers in several emerging economies surprise the markets with interest rate moves out of the blue. Last month, the People’s Bank of China made its first benchmark rate reduction in two years, for example. The Russian central bank recently boosted rates to 17 per cent.
Given that the price of oil and other commodities continues to fall, Capital Economics expects more emerging market central banks to surprise with monetary policy moves and highlights a number that are worth picking out.
“Russia and Nigeria have seen their currencies tumble as oil prices have dropped and, while both we and the consensus expect rate hikes in 2015, there is a good chance that the scale of tightening could turn out to be more aggressive,” the consultancy said.
“In Mexico, we think that there is a good chance of non-consensus rate cuts. Finally, in Turkey the market currently expects rate cuts that we don’t think will materialise, while in Colombia the market expects rate hikes that we don’t think will happen.”
Will US rate hikes trigger further falls in EM markets in 2015?
The past 25 years have seen three major tightening cycles by the Federal Reserve. The return for EM equities was “very poor” in the 12 months after the end of the first cycle, which spanned 1994 and 1995, but “very healthy” after those of the late 1990s and the mid-2000s.
“We suspect that the performance in the first 12 months of the next tightening cycle will be better than in 1994/95, which was largely the result of a currency crisis in Mexico that knocked investors’ confidence in EM equities around the world,” Capital Economics said.
“On the other hand, we doubt EM equities will fare as well as they did in the first year of the cycles that began in 1999 and 2004. In the first case, they rode on the coat-tails of the US dot com bubble. And in the second, the major EM economies had just embarked on a golden period of growth.”
