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Emerging market assets have enjoyed a small reprieve in recent weeks as the Fed rate hike narrative shows signs of shifting towards growth concerns over inflation. While uncertainty is elevated, our baseline expectation is for a stagflationary slump to hit developed markets sometime over the next three quarters, reflecting the impact of the sharp tightening of monetary policy in the United States, energy insecurity in Europe, and ongoing supply-side inflationary pressures. Developed Markets (DM) weakness would be felt unevenly across EM; we expect Eastern Europe and East Asia to bear the brunt of the shock but remain bullish on Latin America.
We do not see any powder kegs (a la the toxic mortgage-backed securities of 2007-08) that could bring DM economies to a stand-still, meaning that any downturn should be more of a simmer – largely engineered by monetary policy – than a bang. The complicating factor is commodity prices – especially energy and food – which we expect to remain elevated on supply-side issues and thus feed inflationary pressures even as overall demand ebbs. Weakness in China (although potentially countered by infrastructure stimulus) and Russia unpredictability form wildcard risks to the commodity outlook, although we see an overall bias to the upside. The upshot: monetary and perhaps fiscal policy will have limited room for stimulus, potentially leading to a prolonged period of DM weakness and investor risk aversion.
Good news first: Latin America looks broadly well positioned to weather the storm, with most of its major economies being diversified commodity exporters to Asia, North America and Europe. Mexico – with a manufacturing economy integrated into US supply chains – is the major exception, although any challenges they face can be as much attributed to dismal policymaking as trade exposures. The region has led the world in hiking rates – Brazil began in March 2021, a full year before the Fed – leaving most countries with a widespread over the US. Together with supportive terms of trade and generally flexible exchange rate regimes, this will help contain external risks. Medium-term external funding needs (current account deficits + external amortization) are low for most major regional economies; based on historical trends, foreign direct investment can be assumed to cover the lion’s share. A myriad of political events across the region (Brazil elections, Chile referendum, new government in Colombia, fragile governments in Ecuador/Peru) could undermine this rosy outlook, although extreme outcomes remain unlikely.
Conversely, Eastern Europe looks vulnerable. The economies of even its non-EU members are highly integrated into continental supply chains, with exports to European countries averaging almost 90% of total exports from the region. Furthermore, Germany – whose industrial sector forms Europe’s greatest vulnerability to the weaponization of Russian energy – is the single largest export destination for every country in the region bar Albania, Croatia and Montenegro. Monetary positioning doesn’t look great either: while some countries, notably Hungary, have been reasonably proactive (or if not proactive, aggressive) in raising rates, much of the region has lagged behind and will have limited options in a crunch. Even in those with monetary headroom, balance of payments pressures stemming from weaker export demand, more expensive energy imports and smaller foreign direct investment inflows will likely be a key limitation, especially given the region’s relatively high exposure to hard currency. Finally, proximity to the Russia-Ukraine conflict adds additional downside; although definitely a tail risk, nothing can be ruled out anymore.
East Asia, comprising some of the most export dependent economies in the world, also looks set for a difficult period. Although exports to Europe and North America only average around 30% of the total across the region, this underestimates the complexity of regional supply chains, with goods gaining value in multiple countries before eventually being shipped to DM consumers. A sustained elevation of energy and food prices would also weaken fundamentals. Monetary positioning is generally well behind the Fed, with most central banks only commencing their hiking cycles since April (if at all). It would be wrong to call this a mistake: Asian economies emerged from COVID restrictions far more slowly than other regions of the world and their inflation dynamics are generally more benign. But with most now running solidly negative real interest rates and indicators pointing to a slowdown across the region, positioning looks awkward. Developments in China will be pivotal; its recent emergence from COVID lockdowns has been a boon to regional demand, but also a reminder that pandemic risks remain material.
It’s not all doom and gloom though. Fiscal metrics in Eastern Europe are sound, with most countries holding moderate debt burdens and high levels of debt affordability, underpinned by EU association and funding. Generous EU disbursements under schemes such as the COVID Recovery and Resilience Facility will help fill balance of payments gaps, with similar schemes for non-members. Meanwhile East Asia is almost entirely financed through its highly developed local markets; formidable external buffers built up over years of current account surpluses further limit downside risks.
These conclusions are of course, subject to a heightened degree of uncertainty; a severe contraction in commodity prices would produce a completely different set of winners and losers, with several major producers carrying less than ideal macro positions. Perhaps the most interesting development, and a testament to the increased robustness of the asset class, is that even after a series of gargantuan shocks to the global economy since 2020 we do not see any evidence of a looming regional sovereign debt crisis: the most serious signs of distress remain embedded in individual economies with long identified credit risks.