Swimming naked? How EM will fare in 2017

Only when the tide goes out do you discover who’s been swimming naked, as Warren Buffett remarked. As far as EMs are concerned, we believe they are well positioned for tighter liquidity in 2017, i.e. greater external funding pressures and higher interest rates. This is due to strong fundamentals and because EMs have already adjusted a great deal to the new environment.

Admittedly, EMs don’t do well when the Fed hikes rates and the dollar rises. This is clear from Figure 1 which shows EM growth during episodes of dollar strength and dollar weakness.


But, EMs have already adjusted a great deal to past dollar strength. Figure 2 compares real external debt across three episodes of dollar strength. The deleveraging is more pronounced than the one in the 1980s and bang in line with that of the 1990s. The same is true for credit growth and current account deficits (not shown).


Also, EM growth has held up much better during the current deleveraging as shown in Figure 3 (which is a simple average, with Russia excluded due to a lack of data). Furthermore, we believe growth will continue to do well, even if the dollar continues to appreciate. The key reason is stronger fundamentals: today the average EM is rated investment grade (EMBIG weighted) versus junk prior to 2008.


To quantify the effect of stronger fundamentals, we looked at 12 emerging market countries over 22 years and distributed each country-year pair into one of five buckets: (1) Weak dollar (2) Strong dollar and very high sovereign rating, (3) Strong dollar and high sovereign rating, (4) Strong dollar and low sovereign rating and (5) Strong dollar and very low sovereign rating. Figure 4 shows the average EM growth rate for each of these buckets. It's evident that a strong dollar dents growth by exposing weak balance sheets. If debt is low, however, this effect is much less pronounced.


The difference in rating between the current and past strong dollar episodes is reflected in the growth difference between columns 3 and 4. Growth should therefore be two percentage points stronger this time around.


There are risks to our favourable EM outlook. Firstly, commodity prices - in particular metals prices - have held up better than expected in the face of a strong dollar. If they returned to levels commonly associated with current dollar levels, EM could suffer. Secondly, a China hard landing could weigh on EM. Finally, Trump's protectionist agenda is likely to be negative for EM. Barring those outcomes, however, emerging markets should do fine.