The Federal Reserve may have just given emerging markets a positive catalyst for 2019. In a recent speech, Governor Jerome Powell finally acknowledged that US fiscal stimulus won’t last forever, monetary tightening hits growth with a lag, and external (read: EM) slowdowns might come back to bite the US. Other Fed speakers subsequently came out to reinforce this message.
It probably didn’t escape their attention that the Fed’s trade-weighted dollar index had just hit a cycle high. While these comments do not particularly change the Fed’s outlook for the next quarter, the possibility of a ‘Fed pause’ in its hiking cycle and a nearing USD top has risen - which would be a very good thing for EMs in 2019.
On the other hand, the outlook for Chinese policy and growth remains concerning, which is a potential headwind for EMs. Policymakers in Beijing realised that ‘something must be done’ and accelerated infrastructure spending in the past two months. However, with overall policy support still piecemeal, and given another month of weak credit data, a significant growth slowdown continuing into 2019 remains a key concern.
Source: Caixin, IHS Markit, Fidelity International, November 2018.
Chinese data painted a soggy picture. On the negative side, the services PMIs published by the National Bureau of Statistics (NBS) and Caixin both slumped, and retail sales data continued to plunge, partly driven by weak auto sales. Even real estate activity looks to be tentatively rolling over, admittedly after a very robust year so far. Leading all of this is weak credit data, as local government bond issuance abruptly has dropped off. Our preferred credit expansion measure, on a 12-month rolling basis, fell to the lowest since Q1 2016; this will weigh on future activity.
On the positive side, infrastructure investment has flipped from a 6 per cent year-on-year contraction to 6 per cent year-on-year growth as Beijing urged local governments to get moving. Similarly, the construction PMI rose to near its highs. Overall, investment data remains fine; private investment rose around 8 per cent year-on-year in nominal terms - but bear in mind, this is the same growth rate as in the US.
Focus on deleveraging and infrastructure
Do not overestimate tariffs as a driver of market moves or China’s domestic policy outlook. More important for market stress has been deleveraging, falling infrastructure spending, and a broken credit transmission mechanism for private companies as banks prioritise ‘safe’ lending to state-backed entities.
Source: China National Bureau of Statistics, Haver Analytics, Fidelity International, November 2018.
Moreover, China’s spending on infrastructure investment is five times the size of its exports to the United States, and the former was allowed by policy to slow from a growth rate of 20 per cent to near-zero. Given this, we find arguments that Beijing might abandon fiscal and financial prudence to counter a one-off hit to growth from US-imposed tariffs to be a bit incongruous.
Source: China National Bureau of Statistics, Fidelity International, November 2018.
EM risks remain to the downside
In conclusion, risks to EMs remain to the downside due to slowing growth in China - where the policy response remains insufficient - and toughening global conditions. EM growth is likely to remain under pressure both from external factors, with the Fidelity Leading Indicator stuck in negative territory year-on-year, and forced tightening in domestic monetary policies.
However, the clear easing off in Fed rhetoric has opened 2019 up to a year of ‘two-way’ risk in financial conditions, and maybe even a Fed pause. This would likely provide respite to beaten-up EM assets, especially in US dollar terms. Lower oil prices would provide another tailwind to many EMs, provided they do not rebound and are not a symptom of demand collapse.
For now, however, stay cautious on outright EM risk. These themes may best be played by avoiding EMs that have been resilient to USD strength but are vulnerable to a slowdown in Chinese trade. Instead, favour those EMs which have been hit by external financing vulnerabilities but are relatively insulated from China.