In the following interview, Michael Gomez, head of emerging markets portfolio management, and Lupin Rahman, emerging markets portfolio manager,discuss the conclusions from PIMCO’s quarterly Cyclical Forum, in which the company’s investment professionals debated the outlook for the globaleconomy and markets. They share PIMCO’s outlook for the emerging markets (EM) over the next 12 months.
Q: What is PIMCO’s outlook for growth and inflation in the emerging markets of Brazil, Russia, India and Mexico (BRIM)?
Michael Gomez: For BRIM as a whole, we expect growth to improve modestly and inflation to fall. The outlook is mixed, however. There are signs of macroeconomicstabilization across most economies, but risks are skewed to the downside as the Federal Reserve raises interest rates and commodities remain at recentlows, suggesting a more bumpy recovery than in previous cycles. The slowdown in China, together with the potential for greater-than-expected currencydepreciation, adds further uncertainty and potential volatility to this outlook.
We expect BRIM growth in 2016 to improve to the 1.25%-2.25% range from 0.5% in 2015, but there is a clear dichotomy. Two of the four economies, Brazil andRussia, are still in recession. Brazil, in particular, is experiencing a sharp contraction on the back of elevated political uncertainty and policygridlock; we expect growth to bottom out in 2016 but fall short of a V-shaped recovery, possibly turning positive only in 2017. The Russian economy willlikely remain weak with the drop in oil prices. By contrast, our forecast is for Mexico to grow about 3%, and we think India will continue to shine withinEM, with growth of about 7.5% in the coming year.
On the inflation front, we expect moderation to 5.5%‒6.5% in BRIM this year from 8.7% in 2015, given base effects and lower pass-through from weakercurrencies. Once again, Brazil is the outlier, where we expect higher-than-consensus inflation. In general, inflation has tended to come down more slowlyin Brazil than in other EM economies because of structural rigidities, such as indexation.
Q: How does the likely path of Federal Reserve monetary policy – PIMCO expects three interest rate hikes in 2016 – affect the outlook for emergingmarkets, both for their economies and financial markets?
Gomez: Historically, EM central banks have followed the Fed, but their flexibility in setting monetary policy has been increasing over time.
The tightening cycles in 1994 and the early 2000s came alongside periods of volatility and crisis in emerging markets, and EM central banks were forced tohike interest rates to shore up their currencies. In contrast, during the 2004 Fed hike, most emerging markets had already delevered and built up largestocks of foreign exchange reserves, giving their central banks more flexibility to tailor the policy response, and the EM rate cycle was relativelyshallow.
Since then, EM flexibility has improved further: Most countries now have floating exchange rates, which should allow their economies to better adjust toexternal shocks than in the past. So looking ahead, while we expect most EM central banks to hike rates eventually, they are better prepared to vary thetiming and pace of their rate increases. This is particularly important because with the current backdrop generally characterized by negative output gapsand contained inflation pressures, most emerging markets (aside from a handful) would prefer to delay hiking rates. Indeed, real rates across EM havediverged markedly over the past year, with Asian real policy rates at recent highs, emerging European real rates close to zero and Latin American ratesshowing wide dispersion. Idiosyncratic factors, such as political dysfunction in Brazil and the impact of low oil prices on Russia’s and Mexico’s fiscalbalances, mean that central bank policy cycles likely will continue to diverge from each other, and from the Fed, rather than be perfectly synchronized.
Q: And how do currencies factor in?
Lupin Rahman: A critical driver for central bank policy will be how EM currencies respond to the Fed tightening. We expect any sharp bouts of weakness will likely befollowed by eventual EM hikes.
One question we always ask ourselves is whether EM currencies have adjusted fully to reflect the latest macro and market developments or whether there ismore to go. On average, EM currencies have depreciated by roughly 20% since January 2014, with some like the Russian ruble and Brazilian real weakening bymore than 40%. While these moves are large and the bulk of the adjustment looks to be done, our sense is that there is more to go, especially ifcommodities remain under pressure. This, together with our outlook for below-consensus growth of 5.5%-6.5% this year in China and our expectation forgradual depreciation and volatility in the yuan, point to further underperformance by Asian currencies (particularly those tied closely to China’s growth)relative to the U.S. dollar.
Q: We have had two downgrades to high yield status among the BRIM economies in the past two years: Brazil and Russia. Are EM credit ratings now in linewith fundamentals or are there pockets of risk overlooked by the market?
Rahman: The combination of a slower China, lower commodity prices and lower secular growth rates for EM no doubt has taken its toll on the credit quality ofemerging markets. The commodity boom was a key driver of the upward ratings migration for EM over the last decade, so with the sharp decline in prices –both oil and iron ore have fallen roughly 40% in the past year alone – this trend has not only stalled but is showing signs of reversing. In addition tothe downgrades of Russia and Brazil, we are seeing an increase in sovereign credit risk with the defaults in Argentina in 2014 and Ukraine in 2015.
Looking ahead, we don’t expect major changes in ratings (in either direction) in the BRIM economies, but within the broader EM universe, we see Turkey,South Africa and the commodity-producing African economies as vulnerable to downgrades. On the positive side, Argentina, which has just elected a newgovernment led by President Mauricio Macri, could see upward rating movement over the next 12 months.
Q: How should investors think about emerging markets in 2016?
Gomez: As we have seen in the opening weeks of 2016, EM remains vulnerable to risk-off sentiment and the cyclical headwinds we mentioned ‒ Fed hikes, China’sslowdown and commodity weakness ‒ as well as lower market liquidity. Bearing these in mind, we are keeping EM positioning light and leaving “dry powder” toadd positions if further market dislocations materialize.
Nevertheless, we see positive signs within emerging markets. Debt servicing capacity has a high resilience to shocks, valuations have adjusted and negativetechnicals may be receding as outflows moderate and gross issuance declines. We think it is still possible that emerging markets could turn the corner overthe course of this year, but we are closely watching how events unfold, particularly with regard to China.
In the meantime, we see opportunity in select parts of the asset class: Short positions in Asian currencies would be our top pick, followed by exposures toselect quasi-sovereigns, where prices already reflect a lot of downside risks but credit quality has a high degree of resilience, in part due to supportfrom solid sovereign balance sheets. We also think some countries with strong fundamentals have fallen in sympathy with the rest of EM over the past yearand may offer good value. Among these are economies, such as Mexico and India, with growing domestic demand and less reliance on commodities and on China.