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EM torn between rosier commodities and hawkish Fed

If you are an emerging market investor, things at least look a little rosier than they did 12 months ago. Then sentiment was souring thanks to doubts about China’s economy, a slumping oil price and plenty of political upheaval.

There is, of course, much to concern the EM universe going into 2017, notably a rising dollar, the prospect of higher interest rates in the US and president-elect Donald Trump’s protectionist promises.

On the plus side of the ledger, commodity prices are robust and there are signs of structural reforms in some countries, while those investors prepared to take the risk will find EM corporate bonds offering some of the best yields in fixed income.

“We are bullish on the long-term outlook for emerging markets due to attractive valuations, structural reforms, a recovery in commodity prices and healthy investment flows,” says Luca Paolini, chief strategist at Pictet Asset Management.

Maybe so, but looking at 2017 there are reasons for EM investors to prepare for it to be as volatile as 2016, a year which began terribly, thanks to those China and oil worries, recovered well around the summer when US dollar and rate expectations were becalmed and then reversed after Trump’s election victory.

US relations with China will cause EM much angst next year. The market has largely ignored the renminbi’s 6.7 per cent depreciation in 2016.

Now, with Mr Trump threatening to name China a currency manipulator straight after his inauguration on January 20, a period of geopolitical tension will probably affect Asian markets that are already under pressure from rising US rates and expectations of tapering in Europe and Japan.

Among the immediate consequences of Mr Trump’s US election is an outflow of funds from emerging market bonds, raising borrowing costs and putting pressure on the countries that borrow most heavily in US dollars.

Investors pulled $1.2bn from emerging market bond funds last week, according to data from EPFR, marking the sixth consecutive week of outflows.

Yields in the JPMorgan index of hard-currency emerging market bonds lifted from a three-year low in late summer to hit an eight-month high of 6 per cent in mid-November. Bond yields move in the opposite direction to prices.

And, according to BofA Merrill Lynch Global Research, a new “fragile three” has emerged this year, with Brazil, Turkey and South Africa more reliant on foreign investment and so most at risk should EM fall out of favour in 2017. While Brazil has improved its current account deficit, both South Africa and Turkey are still struggling.

The other big worry is Venezuela, which heads an index put together by Standard Chartered of countries most likely to succumb to a debt crisis. It is a list that also features Jordan, Argentina and Greece.

“Venezuela’s inability to diversify its economy during the boom years makes it extremely challenging to deal with oil prices that have been 50 per cent below their peak for nearly two years,” says Madder Jha, head of thematic research at Standard Chartered.

Away from the vulnerabilities, there are reasons for optimism. Across EM as a whole, economic growth is projected at 4.7 per cent, says BOFA, led by India and China. Latin America will rebound with 1.5 per cent growth, the bank predicts.

Some believe EM debt returns won’t necessarily be sapped by a strong dollar and rising rates in developed economies, says Zsolt Papp, emerging market debt portfolio manager at JPMorgan Asset Management. Year to date, the main JPMorgan emerging market bond index is up close to 9 per cent and EM bonds offer a higher premium than they did in the wake of the 2013 taper tantrum and are in “fundamentally better shape”, he says.

That’s echoed by Carlos Hardenberg, managing director at Templeton Emerging Markets Group. The cloud of scepticism hanging over the asset class is disguising significant improvements in certain countries, he says, especially those which have adopted reform processes.

“Many countries have benefited to a great extent from commodity prices, which have been at more reasonable levels than in the past,” Mr Hardenberg adds.

However, with the Federal Reserve last week forecasting a steeper path for interest rates next year, EM currencies are once again in retreat. Ongoing dollar strength may result in even more pronounced EM outflows than this year, warn strategists at Japanese bank Nomura. That heralds more capital controls, a practice undertaken by China, Nigeria, Saudi Arabia and Egypt, among others.

“The bottom line is if the pressure on EM flows goes beyond what we have seen thus far, the response may also go beyond what we have seen thus far,” Nomura analyst argue, suggesting Indonesia, Malaysia and India could be next to implement capital controls.

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