Emerging markets (EM) have had a tough go in 2018. While turbulence came from many directions, the two principal headwinds have been Federal Reserve rate hikes and global trade wars. But there are signs of positive change on both fronts as we close out the year. Let’s take a closer look.
First, the Fed. Policymakers have done a relatively good job of normalizing interest rates, with the dollar atypically weakening early in the rate-hike cycle, helping limit the damage to EM currencies. The story shifted this year, however, with the dollar strengthening most of this year in fits and starts, weighing on EM currencies.
But while a December increase in the benchmark federal funds rate appears baked in the cake, Fed Chair Jerome Powell and Vice Chair Richard Clarida recently have indicated that rates are close to neutral, suggesting this year’s relatively aggressive pace no longer may be warranted and that we may be close to the end of this rate cycle. Of course, the Fed continues to stress that all decisions are data dependent, but signs are looking good given that inflation is managed (if not meaningfully absent) and the economy is humming. The upshot for EM currencies: they could have the opportunity to recover some of what they’ve lost this year due to the higher rates. In other words, currencies should reverse course and start appreciating in the absence of U.S. Fed rate hikes.
Trade wars aren’t good for anyone, especially the EM and more so, those that supply China. So it is that the EM suffered as the U.S primarily fought trade battles on two fronts this year, with its North American trade partners Canada and Mexico and with China. We seem to have put the former to bed with Nafta 2.0, i.e., the United States-Mexico-Canada Agreement (USMCA). The agreement signed by the three leaders last week at the opening of the G-20 summit in Buenos Aires now awaits approval from their respective legislatures. This isn’t a slam dunk, as the agreement is subject to revisions. Expect a lot of pushback from the new Democrat-controlled U.S. House, although in the end, we think it’ll probably pass in one form or another.
The trade war with China looks to be more difficult. Each side has raised the ante in a tit-for-tat fury with both the U.S. and China maintaining some dry powder to go a few more rounds. While there is agreement by both sides on some issues, others still seem far away—at least ideologically. Still, the G-20 meeting between Presidents Trump and Xi proved that cooler heads can prevail. The two leaders struck a 90-day truce so their representatives could work on a potential broad agreement. In the interim, Trump put off implementing a new round of tariffs that were to take effect Jan. 1, 2019, and Xi agreed to buy more industrial and agricultural products from the U.S. while reducing or removing tariffs on American cars. Steps in the right direction are always good, and the EM sighed a big relief. To be sure, the U.S.-China trade talks likely will be long and difficult. But we believe that any progress will provide a necessary relief valve to a volatile situation. Considering the negative impact on EM from the U.S.-China trade conflict, I’m reminded of a Swahili proverb: when two elephants fight, it’s the grass underfoot that suffers.
In sum, as we close out the year, we’re watching these interest-rate and trade headwinds closely and remain cautiously optimistic. A reverse course on each will likely result in EM recovering to higher levels.