State Street Global Advisors: The outlook for Emerging Markets

Cyclical factors: deceleration in China, gradual tightening of financial conditions as the Fed normalizes interest rate policy, commodity price weakness, capital outflows and country-specific currency depreciation, debt deleveraging and tepid domestic demand.

Modest Growth Acceleration But Downside Risk
The Emerging Markets (EM) are expected to grow by 4.3% in 2016, modestly up from the estimated 4.2% growth in 2015. Risks, however, are to the downside.
The prospect of a greater-than-anticipated slowdown in China and several geopolitical risks
including the widening conflict in Syria and political turmoil in places like Brazil and Malaysia contribute to the uncertainty.
As it is, Brazil and Russia, both of which are currently in recession, account for the bulk of the anticipated pickup in EM activity in 2016.

Wide Dispersion
Prospects are highly differentiated by region and by country, with emerging countries exhibiting,
as in the developed world, decoupled monetary policy cycles.
In the fourth quarter of 2015, the spread between emerging market and developed market growth rates was at the lowest level in 15 years.
Several factors — the continued slow expansion in the US, the cumulative positive impact of lower oil prices and the easy monetary policies in Europe and Japan — should all be supportive of emerging markets in 2016. Yet, these developing economies face cyclical and secular headwinds.

Many Moving Parts
The upward move in official US interest rates through 2016 also raises concerns that this development might feed a vicious circle by increasing capital outflows from emerging markets.
That would prompt more EM currency weakness, accelerate inflation and promote further interest rate hikes. This in turn could lead to slower growth and corporate debt servicing problems, particularly given the sharp rise in debt levels in recent years.
Some emerging currencies have fallen very sharply in recent months. For example, for the 12 months to the end of October 2015, the South African rand fell 20%, the Turkish lira 24%, the Russian ruble 33% and the Brazilian real 35% against the US dollar.
An estimated 18% of emerging market corporate debt is in hard currencies, and net capital flows (a record approximate $500 billion outflow in 2015) are again expected to be negative in 2016. Those countries with small or non-existent fiscal and current account deficits (“twin deficits”) and robust policy frameworks are best positioned to deal with financial market volatility.

A Delicate Balance
Our core scenario for EM in 2016 is:

• No sharp growth deceleration in China.
• No commodity bust and no overshoot of the US dollar’s value beyond current market expectations.
• A very gradual and well-modulated liftoff in US interest rates.

A negative surprise in any of these areas could lead to financial market volatility, which could reduce EM growth in 2016. Slower medium-term trend growth in emerging markets is already impacting developed markets. And speculation surrounding the pace of firming of US Federal Reserve policy in 2016 has led to major uncertainty.

Growing Share of World Economy
Economists generally use two methods to measure the size of the world economy: the Nominal Exchange Rate method and the Purchasing Power Parity (PPP) method. The former measures total global output at current exchange rates (or average annual exchange rates) and translates everything back to dollars. The latter adjusts for domestic price levels.
On this basis, if the dollar appreciates 20% against the euro, does that mean the eurozone economy is 20% smaller? By one metric yes, by another metric no. Many consumer purchases, for example rent and haircuts, are not tradable in international markets.
And haircuts may be cheaper in the eurozone than in the US. Thus, PPP calculates relative welfare.
For this and other reasons, the IMF calculates the relative size of the global economies on the PPP basis. By this metric, Emerging Markets represent 54% of global output. Under the Nominal Exchange Rate method, which perhaps is a better metric of the relative impact on global aggregate demand of various economies, the IMF values 2014 world output at $78 trillion. By this method, emerging markets represent 38% of the world economy.
Whatever method is used, the share of emerging markets in the world economy continues to grow.

Emerging Markets Snapshot 2016

Emerging Asia
Growth in Asia ex China/India is expected to accelerate from 2.8% in 2015 to 3.1% in 2016. In the ASEAN (Association of South East Asian Nations) countries, all of which are negatively impacted by slower trend growth in China, the Philippines is the main positive performer.

Latin America
The Brazilian economy, Latin America’s largest, will still be in recession in 2016, with output falling 1.9%. By contrast, Mexican growth is expected to accelerate in 2016, reaching 2.8%. Growth is expected to fall from 2.8% to 2.2% in Colombia, an oil exporter, but accelerate modestly in Chile and Peru. With the exception of Brazil, most Latin American countries are expected to raise interest rates in 2016.

Europe, Middle East and Africa
Emerging Europe’s prospects are distorted by geopolitics, from Russia’s entrenchment in Ukraine to Turkey’s proximity to Syria. The Russian economy will rebound in 2016, but growth will be anemic. The Ukraine and refugee crises could dampen growth in the Czech Republic, Hungary, and Poland. Weaker capital inflows could hurt South African growth.