NN IP: Oil helps EM equities

So far, November has been a good month for EM equities, both in absolute terms and relative to developed markets (see Figure 1). Since the beginning of the month, EM has outperformed DM by 3 percentage points. But with EM growth momentum clearly deteriorating and disappointing data, particularly in China, it is not easy to identify the reasons why. Two developments might explain why EM equities have fared a bit better this month. Firstly, the sharp decline in the oil price, which should help contain EM inflation in the coming quarters and bring forward the timing of policy easing. And secondly, the perception among investors that the likelihood of a US-China trade deal has increased.

Let’s start with the oil price and the EM inflation prospects. One of the reasons why emerging debt and currency markets sold off so much in Q2 was the deteriorating inflation outlook due to higher energy prices and their impact on food prices. This then combined with the widening growth differential between the US and the rest of the world, which led to an appreciating US dollar index and weaker EM currencies, making investors reconsider their EM inflation outlook.

In the past months, we have seen EM inflation momentum deteriorating rapidly, to 7% currently from an average of only 3.5% in the first half of the year. The higher oil price and weaker currencies compared to last year should keep EMM inflation elevated, but the sharp decline in the oil price since October and the modest appreciation of EM currencies since September should prevent an inflation increase. So in the margin, the outlook for EM inflation has improved thanks to the lower oil price. This has likely played a role in the recently improved performance of EM equities.

Compared to EM inflation prospects, the expectations for the US-China trade relationship are much more difficult to predict. Fear of US protectionism has played a dominant role in emerging markets this year. Investors have factored in a slower pace of Asian export growth and less foreign direct investments to the region. But now, the announcement of a meeting between the US and Chinese presidents in Buenos Aires on 30 November and some indications that the Chinese side is softening its stance a bit have created new optimism among investors that a trade deal may be in the making.

We still do not believe that a comprehensive trade agreement between the US and China is imminent. However, we cannot deny that there seems to be more room for some kind of de-escalation between the two sides compared to a few months ago. The Chinese have always maintained a pragmatic approach in this area. They need the engine of export growth to manage an orderly growth slowdown as they continue their deleveraging campaign to reduce financial system risks and make growth less credit-driven. Therefore, they will aim for a deal with the US as long as they can avoid losing face.

Urgency for a US-China trade deal has increased

The urgency to strike a deal has increased in recent months due to the bigger-than-expected impact of the announced US tariffs on Chinese business confidence and investments in the manufacturing sector. Moreover, capital outflows from China have increased again in the past two months (see Figure 2), which should be seen as a sign of growing nervousness among Chinese companies and households. With the confidence crisis of 2015-2016 still fresh in their minds, the Chinese authorities will aim to reduce the outflows to avoid more headwinds to growth. A deal with the US, or at least an agreement about future negotiations, would help contain the nervousness at home

Without the (partly justified) optimism about a US-China trade deal, there is little to get excited about concerning EM equities in the coming months. Current EM growth momentum is clearly deteriorating, both on a macro and company-earnings level. After the front-loading of Chinese exports ahead of the 1 January start date for US tariffs, it is almost a given that in the first months of 2019, EM growth will get another hit. And for now, there are no convincing signs that the Chinese policy stimulus will lead to a substantial domestic demand growth pick-up in that period. In light of this, Chinese demand for EM goods is unlikely to increase in the short term. At the same time, capital outflows from EM are keeping financial conditions tight throughout the emerging world. This continues to sustain the pressure on growth.