EM risk and points of inflection from a Fed rate rise

 

We classify current EM risks as points of inflection; the issues that should be closely watched and exacerbated by a hawkish Fed.

1. China is the big elephant in the room when discussing EM. It is hard to even classify China as EM given its size; however, country classification is a different question. The global economy needs a growth driver - a large economy or group that will lift other countries. US monetary policy is working in the opposite direction. The same can be said for the EU, so the focus is on China which has not tightened monetary policy and is attempting to boost growth; however, with a major real estate problem and rolling lockdowns, China has little ability to drive the world economy. In fact, CNY is closing in on 5-year lows.

 

2. The oil shock has sent massive capital flows to the Middle East. Oil exporters are in a great economic shape, but it is less clear that this money will be reversed into global investments that boost other parts of the world. Oil prices have pushed through $80 per barrel, so the oil flow excesses are slowing. 

3. Current account deficits are not as large as past recession periods, and foreign currency reserve coverage is greater for most countries. This minimizes crisis risk, but there are still some countries that will be crisis hotspots even in the EU. 

4. EM bond spreads have widened already and have some distance from US high yield, so there is less risk of a future EM bond shock. However, there is still room for EM HY yields to reach double digit levels.

5. Geopolitical risk both in Eastern Europe and Asia is still high. Lengthened hostilities in Ukraine are more likely to lead to extreme action to break any deadlock. The spillover effect across Europe is high. The China-Taiwan issues have simmered, but there is still high risk which will spillover the surrounding countries. 

6. The Brazil general election on October 2 and the Presidential runoff on October 30 has cast a shadow over the largest economy in Latin America and the president will impact the investment climate. The shift in politics across the continent places downward pressure across capital markets. 

7. The overall decline in international trade places downward on many of the economies that have depended on globalization. While EM domestic growth has surged, economies are still dependent on G7 growth.