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Emerging Markets Still Growing Despite Headwinds

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February 25, 2016
Around the globe: are emerging markets still set to outpace developed nations despite commodity setbacks?

Let the finger-pointing begin. Can early-year stock market volatility and economic uncertainty be traced to emerging markets? Sure, at least in part. After all, China's economy is in slowdown mode (from its breakneck double-digit growth pace pre-2008 crisis). Simply put, the Chinese are demanding less crude oil, copper, or grains now, and that crimped demand ripples through the typically economically sensitive emerging markets.

Widening the lens, commodity exporters—notably Latin American economies—were hit hard by last year's collapse in commodity prices. Throw in last year's U.S. Federal Reserve interest rate hike, which raises the fear of higher borrowing costs for emerging economies, and emerging markets are seeing some challenges, to put it lightly.

What might traders expect from emerging markets for the remainder of 2016? Let's take a look.

Global growth is expected to hold steady at 3.1% in 2016, according to a Nomura Securities research note, with emerging market growth once again outpacing growth in advanced or developed nations. In 2015, emerging market countries as a group churned out a 4.2% growth rate overall versus a 1.8% pace in developed nations. The picture for 2016 is similar, as Nomura pegs emerging market GDP steady at 4.2% this year. Developed nations are expected to ratchet down to a 1.7% pace.

Who, What, and Where?

First, some basics. Emerging markets are countries that are considered to be catching up to advanced economies in terms of income per capita. Generally, this includes most of the world outside of North America, Europe, Japan, and Australia/New Zealand.

Emerging markets are big. They represent a disproportionate fraction of the global economy. "Emerging markets represent between 57% and 58% of world GDP on a purchasing power parity [PPP] basis. Major emerging market economies include China, India, Russia, Turkey, Saudi Arabia, Iran, Nigeria, Mexico, Brazil, and some of the ASEAN member nations such as Indonesia," explains Fotios Raptis, senior international economist for TD Economics at TD Bank Group.

Emerging markets index

FIGURE 1. EMERGING MARKET HEADWINDS.

The FTSE Emerging Index (AG01:FTSE) tracks stocks in countries like China, India, Russia, and Brazil, among other emerging markets. Data source: FTSE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Key Drivers

Recently, the commodity sector price collapse and the Federal Reserve’s shift to tightening mode have been two major factors with a negative impact on emerging market economies. However, emerging market nations can be viewed in two groups: commodity exporters and those who are net importers of commodities. "The drop in commodity prices doesn't hurt all emerging market economies. Commodity importers like China and India should benefit," Raptis says.

Meanwhile, the Federal Reserve's switch to a rising interest rate environment last year sent tremors through emerging market economies. "The Fed cycle of rate hikes imposes pressures on most emerging market economies, since that implies capital outflows from emerging markets returning to the U.S.," says Alfredo Coutiño, director for Latin America at Moody's Analytics.

As most seasoned investors know, fundamentals aren’t the only drivers for markets. Sentiment can be a major mover, too.

Investor sentiment toward emerging markets could remain a key factor in overall financial performance this year. "Much of the volatility so far this year has been an overreaction by the market to poorly communicated exchange rate and financial market interventions by Chinese authorities. This is a theme carried over from 2015 that will continue this year as Chinese authorities and their policy responses will continue to act as a bellwether for emerging market bonds and equities," Raptis says. Stay tuned.

Can Commodities Stay Down for Long?

The major cyclical downturn in commodity markets from crude oil to copper to soybeans has severely dented economic growth in a number of major emerging market commodity exporters. If commodities can find a toehold in 2016, that could help lend some support to these economies. "Several commodity producers are already in relatively deep recessions—Russia and Brazil. These countries should see some stabilization over the next year as commodity prices stabilize. Growth will remain weak, but the free fall should cease," Raptis says.

Big commodity producers like Brazil have been hit especially hard, as the commodity price collapse last year created a huge income shock for the nation. Nomura forecasts an overall negative 2.8% growth rate for Brazil in 2016 as the country remains mired in recession following its negative 3.6% GDP performance in 2015. "Brazil is dealing with an inflationary spiral—pushing policymakers to tighten interest rates to support the real, [which] worsens the impact on the domestic economy. Problems are exacerbated by lack of fiscal room—having to tighten into a downturn," Raptis says.

Bright Spots and Weak Spots

For intrepid investors who are willing to look out on the risk curve, there are bright spots within the emerging market picture. "The rising star of emerging markets is definitely India with steady and solid growth and a promising agenda of reforms, followed by a few countries in Eastern Europe as well as Mexico, which are already deepening structural changes and opening their economies further," Coutiño says.

Latin America, with its heavy dependence on commodity exports, may remain the weak link this year in the emerging market basket. Latin America also faces the general lack of fiscal and monetary policy room to aid the necessary economic diversification away from commodities, Raptis says. "In the near term, this region presents a great play for risk-loving investors with a longer time horizon. The Middle East/North Africa region is a potential minefield for investors given the region's dependence on oil exports and the threat of political instability mainly due to multinational terrorist groups," Raptis adds.

And, Next?

With the fastest pace of global growth stemming from emerging market economies, this sector could continue to play an important role for advanced markets, too. China will likely continue to play a starring role in global market action with several headwinds still in place there. "China's economy will continue to rebalance away from debt-driven investment and toward consumption, a process that is likely to take several more years and see further deceleration in economic growth rates. Slower Chinese growth will weigh on its trading partners in Asia," concludes Raptis.

The Federal Reserve is monitoring global economic developments, which will play into its decision on when to hike interest rates next. "Although the direct trade linkages are small between the U.S. and individual emerging market economies, a protracted synchronous decline in economic activity among some of the larger emerging markets will probably force the Federal Reserve to delay further tightening," Raptis notes.

In the end, sentiment and confidence—or the lack of it—may be important factors for global financial markets this year. "What's important to acknowledge is that the indirect linkages, such as how a slowdown in China affects business and consumer confidence domestically, as well as the lack of transparency concerning which and how deeply U.S. financial intermediaries are exposed to emerging markets, are more likely to drive the reaction in U.S. financial markets," Raptis concludes. 

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