Expect Further Divergence in Emerging Market Economies by Michael A. Gomez, Lupin Rahman, PIMCO
- Our baseline for Brazil, Russia, India and Mexico overall is growth of 1.5%–2.5% year-over-year through first-quarter 2016, with negative output gaps for Brazil and Russia in particular.
- Our baseline is that emerging market as a whole is likely to be able to weather a gradual and predictable Fed exit, but that there may be volatility and accidents along the way.
- We are focusing on select opportunities across countries, credits and markets.
Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy and financial markets. In the following interview, portfolio managers Michael Gomez and Lupin Rahman discuss PIMCO’s cyclical outlook for the emerging markets (EM).
Q: What is PIMCO’s outlook for growth and inflation in emerging market?
Lupin Rahman: Differences across emerging market countries in initial conditions, commodity reliance and sensitivity to U.S. Federal Reserve and dollar moves suggest we are likely to see further divergence in economic outcomes over the next few quarters. Our baseline for the BRIM (Brazil, Russia, India, Mexico) economies as a whole is growth of 1.5%–2.5% year-over-year through the first quarter of 2016, with output gaps in the negative territory for most countries, particularly Brazil and Russia. BRIM inflation is forecast to print around 6.0%–7.5% year-over-year with risks to the upside. Overall, we expect to see greater dispersion across countries, with the commodity-exporting bloc likely to face stagflationary pressures as currency weakness keeps inflation high and sticky, even as Asian and Eastern European importers experience disinflation due to lower energy prices.
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Q: How will U.S. policy normalization and dollar strength affect emerging market?
Mike Gomez: Historically, Fed tightening cycles have been associated with volatility in emerging market, and in light of emerging market’s sharply negative reaction to the 2013 “taper tantrum,” investors have naturally questioned how resilient the asset class will be in the face of an eventual Fed liftoff. Our baseline is that EM as a whole is likely to be able to weather a gradual and predictable Fed exit, but that there may be volatility and accidents along the way.
Underpinning this view is the reality that most emerging markets are entering this cycle with higher foreign exchange (FX) reserve buffers, lower external indebtedness and more flexible exchange rate regimes, all of which leave them better positioned to withstand higher “risk-free rates” and a potentially extended period of U.S. dollar strength. Policy frameworks are also generally stronger, allowing several central banks to deploy countercyclical rate cuts despite FX weakness and prospective Fed hikes. This is a marked departure from past experience.
That said, the recent period of plentiful global liquidity has produced pockets of froth. For example, since 2008 we have seen increased leverage in China and, more generally, higher external leverage on emerging market corporate balance sheets. These are areas to keep an eye on and ones where we are focusing our bottom-up analysis to help us better distinguish where vulnerabilities might exist. We also expect differences across regions, particularly as the European Central Bank and Bank of Japan QE will likely be more supportive of emerging Europe and Asia, leaving Latin American commodity exporters more vulnerable.
Q: Mexico’s economy has historically been highly correlated with the U.S. How does PIMCO expect Mexico to navigate the Fed liftoff from zero?
Rahman: Mexico has navigated the post-crisis period relatively well and is progressing steadily on its planned structural reforms. Recent economic data point to a dovish central bank bias given weak activity indicators, decreasing inflation and the ongoing drag from steady fiscal consolidation. These domestic factors, together with the weaker peso and financial stability considerations, are likely to be driving factors for the Bank of Mexico’s (Banxico) rate decisions. Our baseline, in line with recent comments from the central bank, is for any policy shift from Banxico to be well-telegraphed and in lock-step with the Fed. Nevertheless, in the event of an adverse market reaction, Mexico has strong policy buffers including the potential to increase FX interventions, the availability of International Monetary Fund/Fed lines and the potential for local debt buybacks and other policy levers.
Q: Have emerging markets adjusted to lower commodity prices?
Rahman: Our bottom-up analysis indicates that, in addition to allowing their currencies to weaken to absorb some of the initial shock, many exporters have already started to consolidate their fiscal balances using more conservative commodity price assumptions for their 2015 budgets. However, some countries are already behind the curve, both in terms of treating lower prices as a more permanent shock and being unwilling to adjust rigid policies on fiscal expenditures and exchange rate regimes.
As for commodity importers, many appear to have adjusted rather rapidly to lower prices, with some proactively using the declines to alleviate the fiscal drag of subsidized domestic energy consumption. These economies are already benefitting from lower current account deficits and improved fiscal balances due to the savings from lower oil prices and, as a result, they are seeing greater underlying support for their currencies.
Over the next few quarters, we expect further adjustments from both importers and exporters. Some will take advantage of the opportunity to make difficult structural adjustments, while others will take a more myopic view and look to smooth the shock as a short-term phenomenon.
Q: What is PIMCO’s general outlook for Russia? Are there any areas for optimism?
Gomez: Russia is likely to face continued headwinds given the drop in oil prices as well as constraints due to geopolitical tensions, which are showing limited signs of near-term resolution. We expect the country to undergo a deep recession and inflation running in the mid-teens. Nevertheless, the combination of a current account surplus and drawdowns in the existing stock of FX assets should be more than sufficient for Russia to cover its upcoming external obligations. This baseline is contingent upon a somewhat orderly financial environment in Russia and assumes a continuation of the status quo in eastern Ukraine, albeit with occasional flare-ups of violence. We recognize there are tail risks to this, both good and bad, but the pricing of Russian assets suggests the market is more skewed toward the left tail of the distribution of outcomes. Thus, we see opportunity, particularly among issuers with strong free-cash-flow generation.
Q: Brazil appears to be progressing on the reform front, albeit with many challenges ahead. Can the new financial team’s focus on reforms bring a return to growth in 2016?
Rahman: We expect 2015 to be another difficult year for Brazil, with macroeconomic risks compounded by several negative shocks including potential energy rationing, the Petrobras scandal and the adjustment to lower commodities prices. Our baseline is for a contraction of 0.5%–1%, with meaningful downside risks given the potential for lower investment from the energy sector and lower external demand given the drop in commodities. Meanwhile, inflation will remain high and above the 6.5% upper bound of the inflation target range as the upward adjustment in regulated prices continues and recent currency weakness passes through to prices. This challenging macro backdrop together with a more difficult political landscape make the planned fiscal adjustment even more critical to foster confidence in the government and improve the business environment in 2016 and beyond.
We expect to see Finance Minister Joaquim Levy deliver a fiscal adjustment close to his initial announcement using a combination of cyclical measures such as discretionary spending cuts as well as some progress on expenditure and tax reforms. Fiscal consolidation, along with improved central bank credibility and movement in the exchange rate toward a more flexible and fair level for the currency, should go a long way toward addressing the recent buildup of imbalances and eventually underpin strong growth in the medium term.
Q: What are the investment implications of PIMCO’s cyclical outlook for EM?
Gomez: Taken together, the backdrop suggests a high degree of differentiation is required ahead in the emerging market asset class, and PIMCO is focusing on select opportunities across countries, credits and markets. While currencies remain the most vulnerable given their role as the macro release valve, we see value in a scaled basket of EM long positions funded with non-U.S. dollar core currencies to remove the dollar risk, particularly in emerging market currencies that have already adjusted significantly. We remain cautious on overall duration given valuations, and instead prefer to express emerging market longs versus shorts in core rates markets that appear fully priced. Finally, we remain focused on strong-balance-sheet credits in the sovereign and corporate space, which we view as relatively more anchored in the current global backdrop of lower commodities prices and desynchronized global central bank actions.