As the political turmoil and high stock valuations in the U.S. create an uncertain market for investors, emerging markets appear to be facing a goldilocks global environment. Fairly synchronized growth recovery, low inflation and amply accommodative monetary policy in advanced economies have created a sweet spot for the developing nations.
Indeed, growth is picking up in advanced economies, which is good for emerging markets as it boosts global trade. With the pace of global industrial production having doubled from a year ago, advanced economies are seeing the most improvement. A future growth slowdown could hurt emerging markets, but these clouds are distant at the moment.
Despite the current recovery, inflation in advanced economies remains remarkably subdued, and looks less likely to hit the official targets as early as the authorities had hoped. The U.S. economy remains on solid footing, but inflation and wages have continued to weaken, and several arguments suggest wages could remain softer for longer, which would work against global central bank removing the international liquidity punchbowl too fast. In the Eurozone, headline inflation remains below target too. In Japan, for its part, zero-rate inflation expectations are deeply ingrained.
Luckily for emerging markets, global monetary policy conditions remain amply accommodative (low interest rates) by historical standards, and normalization in coming quarters should be very gradual.
Indeed, recent central bank language in advanced economies suggests no rush to tighten policy abruptly. In Europe, ECB Chief Mario Draghi has recently emphasized the uncertainty surrounding the inflation outlook and said that there has been no debate yet on either the timing or direction of the ECB's next move. This suggests the process will probably be more gradual and less automatic than the markets might have expected. While the ECB will likely contemplate gradually slowing its accommodation later this year, there is yet no sense of emergency to tighten policies outright.
As for the U.S., the Fed seems unlikely to hike its interest rate again before 2018. In fact, over the last several quarters, the FOMC's "dot plot" of projected rate hikes has steadily converged towards the market pricing of much less tightening – rather than the other way around. While U.S. labor markets have clearly tightened, inflation remains remarkably subdued, calling into question traditional estimates of the so-called Phillips curve - or the empirical relationship between inflation and unemployment.
Crucially, the U.S. dollar probably has peaked. A combination of less Fed tightening than the authorities had indicated before and prospects for diminished scope for U.S. fiscal expansion should work to sap the U.S. dollar. In the larger scheme of things, it seems clear that the U.S. dollar goes through broad, multi-year cycles. Beyond near-term corrections, medium-term prospects seem to indicate U.S. dollar weakening for the next few years.
In turn, a weaker U.S. dollar should be very good news for emerging markets, for many reasons. First, if the U.S. dollar weakens against all other currencies, then it follows that emerging markets' currencies would appreciate against the U.S. dollar. Second, a weaker dollar tends to spur international capital flows to emerging markets. Third, strong empirical evidence suggests that a weaker U.S. dollar boosts commodity prices.
Commodity prices should gain support from three aspects of a weaker U.S. dollar. First is the direct valuation effect, as commodity prices are quoted in U.S. dollar terms. Second is the "financialization" of commodities: as commodity futures have evolved into a financial asset class, the link between prices and the financial transmission channel has become crucial. Third is the China link: because the Chinese currency is a "pseudo peg" against the U.S. dollar, a weaker U.S. dollar means a weaker RMB too, against a basket of other currencies. A weaker RMB would tend to be expansionary for the Chinese economy. China is a major global consumer and importer of commodities, and commodity prices tend to rise with increased Chinese demand.
In sum, a global backdrop of decent growth, low inflation and accommodative global monetary policies could feel like nirvana for emerging markets, along with a weaker U.S. dollar that could boost emerging markets currencies. While this environment could lift many emerging markets boats, commodity-exporting Latin America would likely benefit the most from a rising tide of commodity prices.
Commodity prices indeed matter a lot for currency valuation estimates in Latin America, as they are relevant for current account developments. In Brazil, for instance, Brazil's real is highly correlated with commodities. Global prospects thus reinforce my long-held, high-confidence, out-of-consensus view that the Brazilian real will be much stronger this year than markets have anticipated: I see the real hitting 3.0 this year – if not stronger. In turn, a stronger real would also reinforce my high-conviction, long-held view that domestic interest rates in Brazil will fall to 7.0 percent (if not lower), well below what markets and consensus first expected.
Commentary by Marcelo Carvalho, head of Emerging Market Research, Latam at BNP Paribas. Follow him on Twitter @MCarvalhoEcon.
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