Emerging Markets Explorer - SEB Group · 4 Emerging Markets Explorer SEB EM Forecasts FX Rates (end of period) Policy Rates (end of period) 26-Nov-2018 Spot 1M 4Q-18 1Q-19 2Q-19 3Q-19

Emerging Markets Explorer

December 2018

Editor

Per Hammarlund

Contributors

Martin Carlens Ann Enshagen Lavebrink Eugenia Fabon Victorino

Olle Holmgren Melody Jiang Andreas Johnson

Bjarne Schieldrop Sergey Veshchikov

Cut-off date: Thursday, 22 November 2018

Emerging Markets Explorer 3

Contents SEB EM Forecasts 4

Executive Summary 5

Slowing global growth and choppy markets ahead 6

Oil — OPEC+ can and will cut production if needed 8

USA — What if growth slows abruptly? 10

China — Spotlight on imports 12

India — Markets swinging with oil prices 14

Country Section 17

Asia 17

China 17

Indonesia 17

Korea 18

Malaysia 18

Philippines 19

Singapore 20

Thailand 20

Emerging Europe 21

Russia 21

Poland 21

Turkey 22

Czech Republic 23

Ukraine 23

Latin America 24

Brazil 24

Mexico 24

Sub-Saharan Africa 25

South Africa 25

Disclaimer 26

4 Emerging Markets Explorer

SEB EM Forecasts

FX Rates (end of period) Policy Rates (end of period)26-Nov-2018 Spot 1M 4Q-18 1Q-19 2Q-19 3Q-19 4Q-19 26-Nov-2018 Current Next 4Q-18 1Q-19 2Q-19 3Q-19 4Q-19

vs. EUR Rate MPC

PLN 4.29 4.35 4.25 4.15 4.10 4.05 4.05 Asia

HUF 322.1 330.0 325.0 320.0 320.0 315.0 315.0 China Lending 4.35 -- 4.35 4.35 4.35 4.35 4.35

CZK 25.90 25.90 25.20 24.80 24.50 24.50 24.50 Deposit 1.50 1.50 1.50 1.50 1.50 1.50

TRY 5.99 5.82 5.71 6.22 6.90 7.61 7.67 RRR 14.50 14.50 14.00 14.00 14.00 14.00

RUB 75.59 74.02 72.80 74.58 77.05 78.98 80.24 South Korea 1.50 Nov 30 1.50 1.50 1.50 1.50 2.00

vs. USD India 6.50 Dec 5 6.75 6.75 7.00 7.00 7.00

RUB 66.55 65.50 65.00 66.00 67.00 67.50 68.00 Indonesia 6.00 Dec 20 6.00 6.25 6.50 6.50 6.50

TRY 5.27 5.15 5.10 5.50 6.00 6.50 6.50 Malaysia 3.25 Jan 24 3.25 3.25 3.25 3.50 3.50

PLN 3.78 3.85 3.79 3.67 3.57 3.46 3.43 Philippines 4.75 Dec 13 4.75 4.75 5.00 5.00 5.00

HUF 283.6 292.0 290.2 283.2 278.3 269.2 266.9 Thailand 1.50 Dec 19 1.75 1.75 2.00 2.25 2.25

CZK 22.80 22.92 22.50 21.95 21.30 20.94 20.76 Taiwan 1.375 Dec 20 1.375 1.50 1.50 1.50 1.50

UAH 27.83 28.25 28.25 29.50 30.00 30.00 30.50 Emerging Europe

BRL 3.83 3.65 3.65 3.70 3.85 4.05 4.25 Poland 1.50 Dec 5 1.50 1.50 1.50 1.75 2.25

MXN 20.36 20.50 20.50 20.00 20.00 21.00 21.50 Czech 1.75 Dec 20 2.00 2.25 2.25 2.50 2.50

ZAR 13.76 13.50 13.50 14.30 14.80 15.20 15.50 Hungary 0.90 Dec 18 0.90 0.90 1.00 1.50 2.00

CNY 6.94 6.95 6.95 6.91 6.87 6.83 6.75 Turkey 1W repo 24.00 Dec 13 24.00 24.00 22.00 20.00 18.00

CNH 6.93 6.95 6.95 6.91 6.87 6.83 6.75 O/N Borrowing 22.50 22.50 22.50 20.50 18.50 16.50

HKD 7.82 7.84 7.84 7.83 7.82 7.82 7.80 Late Liq Lend Rate 27.00 27.00 27.00 25.00 23.00 21.00

IDR 14,476 15,000 14,950 14,795 14,640 14,485 14,175 Russia 7.50 Dec 14 7.50 7.75 8.00 8.00 8.00

INR 70.60 70.00 74.00 73.32 72.64 71.96 70.60 Ukraine 18.00 -- 17.00 16.50 16.50 16.00 15.00

KRW 1,129 1,120 1,135 1,123 1,111 1,099 1,075 Latin America

MYR 4.19 4.14 4.15 4.12 4.09 4.06 3.99 Brazil 6.50 Dec 12 6.50 6.50 6.75 7.00 7.25

PHP 52.37 54.30 54.00 53.56 53.12 52.68 51.80 Mexico 8.00 Dec 20 8.25 8.25 8.25 8.00 7.50

SGD 1.37 1.37 1.38 1.37 1.36 1.35 1.33 Sub-Saharan Africa

THB 33.02 32.60 32.90 32.52 32.14 31.76 31.00 South Africa 6.75 Jan 22 6.75 7.00 7.00 7.50 7.50

TWD 30.88 30.70 31.00 30.71 30.43 30.14 29.57 Developed Markets

EUR/USD 1.14 1.13 1.12 1.13 1.15 1.17 1.18 United States 2.25 Dec 19 2.50 2.75 3.00 3.00 3.00

USD/JPY 113.2 112.0 112.0 109.0 108.0 106.0 104.0 Eurozone 0.00 Dec 13 0.00 0.00 0.00 0.25 0.25

Source: Bloomberg, SEB

Real GDP Consumer Price Inflation2015 2016 2017 Latest 2018 2019 2020 Target Latest 2016 2017 2018 2019 2020

SEB EM Aggregate 4.4 4.6 5.0 % y/y 4.9 4.8 4.8 2018 % y/y

Asia Asia

China 6.9 6.7 6.9 6.5 Q3 6.6 6.3 6.1 China 3.0 2.5 Oct 2.0 1.6 2.1 2.3 2.3

India 7.6 7.9 6.2 8.2 Q2 7.8 7.6 7.4 India 4.0 (±2) 3.3 Oct 5.0 3.3 4.3 4.8 5.0

Indonesia 4.9 5.0 5.1 5.2 Q3 5.1 5.0 5.0 Indonesia 2.5-4.5 3.2 Oct 3.5 3.8 3.2 3.7 4.0

South Korea 2.8 2.9 3.1 2.0 Q3 2.6 2.5 2.7 South Korea 2 2.0 Oct 1.0 1.9 1.6 1.9 2.1

Singapore 2.2 2.4 3.6 2.2 Q3 3.4 2.9 2.6 Singapore -- 0.7 Oct -0.5 0.6 0.6 1.3 1.6

Philippines 6.1 6.9 6.7 6.1 Q3 6.3 6.2 6.1 Philippines 3.0 (±1) 6.7 Oct 1.8 3.2 5.3 4.2 3.6

Malaysia 5.1 4.2 5.9 4.4 Q3 5.0 4.8 4.8 Malaysia 2.0–3.0* 0.6 Oct 2.1 3.6 1.1 1.6 1.8

Taiwan 0.8 1.4 2.9 2.3 Q3 2.3 2.3 2.2 Taiwan -- 1.2 Oct 1.4 0.6 1.5 1.3 1.3

Thailand 3.0 3.3 3.9 3.3 Q3 4.5 4.1 3.9 Thailand 2.5 (±1.5) 1.2 Oct 0.2 0.7 1.1 1.4 1.5

Emerging Europe Emerging Europe

Poland 3.8 3.1 4.8 5.1 Q3 5.1 3.5 3.2 Poland 2.5 (±1) 1.8 Oct -0.6 2.0 1.9 3.0 2.5

Czech Republic 5.3 2.5 4.3 2.3 Q3 2.8 2.6 2.9 Czech Republic 2.0 (±1) 2.2 Oct 0.7 2.5 2.2 2.5 2.5

Hungary 3.4 2.2 4.0 4.8 Q3 4.6 3.0 2.6 Hungary 3.0 (±1) 3.8 Oct 0.4 2.3 3.0 3.5 3.0

Turkey 5.9 3.2 7.4 5.2 Q2 3.5 1.5 3.5 Turkey 5.0 25.2 Oct 7.8 11.1 17.0 20.0 10.0

Russia -2.5 -0.2 1.5 1.3 Q3 1.6 1.6 2.0 Russia 4 3.5 Oct 7.1 3.7 2.8 4.6 4.1

Ukraine -9.8 2.4 2.5 2.8 Q3 3.2 3.2 3.1 Ukraine 8.0 (±2) 9.5 Oct 14.9 14.5 11.0 8.5 7.5

Latin America Latin America

Brazil -3.5 -3.5 1.0 1.0 Q2 1.1 2.5 2.6 Brazil 4.5 (±1.5) 4.6 Oct 8.8 3.5 3.8 4.2 4.4

Mexico 3.3 2.9 2.1 2.5 Q3 2.3 2.1 2.5 Mexico 3.0 (±1) 4.9 Oct 2.8 6.0 4.9 3.5 3.0

Sub-Saharan Africa Sub-Saharan Africa

South Africa 1.3 0.6 1.3 0.4 Q2 0.6 1.8 2.2 South Africa 3.0–6.0 5.1 Oct 6.3 5.3 4.7 5.5 5.3

Source: IMF, OECD, Bloomberg, SEB * BNM Forecast. Source: Bloomberg, SEB


Executive Summary

Macro overview

The theme of this EM Explorer is “Trade, Trump and Treasuries”. The terms capture what will be the key factors affecting EM over our forecast horizon, i.e., the next 3–9 months. When it comes to trade, or expansion of the world economy, conditions have deteriorated in 2018, pointing to a slowdown in growth, albeit from a high level. “Trump” is shorthand for politics, which will be challenging and have a dampening effect on investor sentiment towards EM. Lastly, treasuries signify interest rates, which will rise driven partly by the US Fed and partly by local factors.

The single-most important factor will be global and EM economic growth. While we expect growth to remain high, slowing only gradually, the main concern will the direction of growth, not the level. As growth moderates, EM asset prices and currencies will trend downwards. However, since we expect global and EM economic growth to be good, the trend will be disrupted by extended periods of appreciation and stability. EM FX markets are currently in such a period of relative stability. While periods of heavy selling will provide opportunities for investors to buy EM assets, market recoveries when yields moderate will be a good time for corporates to review hedging needs, focusing on currencies with economies running large current account deficits.

Theme articles

Oil — OPEC+ can and will cut production if needed

• Russia and Saudi Arabia differ on oil price. But they agree on the need to prevent inventories outside the US from rising again. We stick to our $85/bbl oil price forecast for 2019, boosted by an expected agreement to limit output.

USA — What if growth slows abruptly?

• The US economy continues to perform strongly and so far there are few signs of sharp deceleration. We expect economic activity to slow only gradually in 2019 and 2020. This scenario should be manageable for emerging market economies. However, a much more abrupt slowdown in US growth is non-negligible risk. In one of our theme articles we discuss the implication for emerging markets.

China — Spotlight on imports

• Despite higher US tariffs, China’s exports continue to beat market expectations. A recent surge in imports implies sustained improvement in investment. Changing consumption patterns, not headline GDP growth, will drive global trade.Ongoing vertical integration has led to less reliance on intermediate and capital imports. Imports of commodities and consumer goods are increasing due to a rebalancing of China’s economy.

India — Markets swinging with oil prices

• The Indian rupee and the Sensex equity index have both lost roughly 10% in 2018. However, real GDP is growing strongly, which together with lower oil prices in the near term and tight monetary policy, will help stabilise markets. Unpopular reforms of the labour market and regulations surrounding land purchases will be on hold until after next year’s elections. However, reforms will be necessary if the government will succeed in keeping growth around 7% per year beyond 2019.


Slowing global growth and choppy markets ahead

• Global and EM growth rates are slowing.

• Periods of broad selling are likely to occur, driven by

investor concerns about one or more markets.

• The most vulnerable currencies will be in economies

with current account deficits financed by portfolio

investment flows.

• With still-decent growth, periods of sharp price

declines will present opportunities to buy

The theme of this EM Explorer is “Trade, Trump and Treasuries”. The terms capture what will be the key factors affecting EM over our forecast horizon, i.e., the next 3–9 months. When it comes to trade, or expansion of the world economy, conditions have deteriorated in 2018, pointing to a slowdown in growth, albeit from a high level. “Trump” is shorthand for politics, which will be challenging and have a dampening effect on investor sentiment towards EM. Lastly, treasuries signify interest rates, which will rise driven partly by the US Fed and partly by local factors.

The single-most important factor will be global and EM economic growth. While we expect growth to remain high, slowing only gradually, the main concern will the direction of growth, not the level. As growth moderates, EM asset prices and currencies will trend downwards. However, since we expect global and EM economic growth to be good, the trend will be disrupted by extended periods of appreciation and stability. EM FX markets are currently in such a period of relative stability. While periods of heavy selling will provide opportunities for investors to buy EM assets, market recoveries when yields moderate will be a good time for corporates to review hedging needs, focusing on currencies with economies running large current account deficits.

Falling PMIs drag down EM currencies

SEB’s EM aggregate GDP expanded by 5.0% in 2017, but will slow to around 4.9% in 2018 and 4.8% in 2019. SEB’s Global Leading Economic Indicator (GLEI) points to a relatively mild slowdown over the coming 6–9 months. Nevertheless, the level is not as important as the direction.

To overestimate the importance of growth for EM assets is difficult. Markit’s EM manufacturing PMI has been on a downward trend since December 2017, coinciding closely with the selloff in EM assets, in particular EM FX. Both the EM manufacturing PMI and EM currencies recovered in October. However, with the flash PMIs for the EU and Japan moderating in November and those for the US being mixed (the ISM is pointing up, while the Markit PMI is pointing down), the outlook for the remainder of 2018 and early 2019 is sombre.

The GDP slowdown is affecting all EM regions. However, in EM Asia the moderation has been milder and more gradual than in EMEA and Latin America. The sharp drop in growth in Latin America was driven primarily by the truckers’ strike in Brazil and a sharp slowdown in Argentina. Turkey is the key factor behind the drop in EMEA. The graph below also captures which regions are most likely to see heightened market volatility.

While not all EM economies are equally dependent on trade, export and import data are important indicators of manufacturing and the global business cycle. Despite tariffs imposed by the US on imports from China, Chinese trade is holding up remarkably well, with imports growing by 21% y/y in October in USD terms and exports by 15%. The numbers may be pushed up by companies front-loading shipments now before tariffs may increase on January 1 2019. Nevertheless, compared to the slowdown in 2014–2015, global trade is doing better, which should mean that EM selloffs will not be quite as severe and prolonged as they were in that period.


A key risk, as we have pointed out previously in the EM Explorer, is a sharper than expected economic slowdown in China. According to the Institute of International Finance (IIF), real GDP growth is barely above the trough seen in 2015/2016, when its monthly GDP growth tracker bottomed out at just below 5% y/y growth. Nevertheless, the Chinese authorities have fiscal room to stimulate growth and they are pushing banks to increase lending to the private sector. In the long term, risks associated with excessive debt levels in China remain, but over the coming 2–3 years, we expect the government to manage a soft landing. The authorities are committed to deleveraging and reorientation of the economy away from investment to consumption, which over time will lower headline GDP growth. However, anecdotal evidence suggests that the number of worker strikes and work-place disputes have increased markedly in 2018. The government will use a combination of economic stimulus and suppression to make sure that these strikes do not threaten government stability.

Another risk that could cause growth to drop more precipitously is a US-China trade war. The risk of an escalation will hang in the air at least until the end of President Trump’s term in office. However, given rising voices of concern among US corporations of the effects of a full-scale trade war with China, we expect President Trump and President Xi to reach some form of agreement potentially already at the G20 meeting in Argentina that ends on December 1 that will cause the US to delay tariff hikes scheduled for January 1.

So far the effects of the US-China trade war have been mild, affecting less than 2% of global trade. Nevertheless, while the negative headlines dominate, there has been progress on free trade at the same time. The EU and Japan signed a trade agreement in June, and Japan and China issued a declaration that they will work on freeing trade and investment. Progress will be slow, but the intention appears to be genuine. Canada is reviewing the WTO dispute resolution mechanism. In addition, in a sign of President Trump’s need and willingness to strike deals, an agreement with Mexico and Canada to replace NAFTA with the USMCA was reached in September. In addition, the US-China trade war may boost economies surrounding China as production moves off shore.

Benign inflation outlook

We have raised our EM inflation forecast slightly for 2020 to 3.5%, but it remains low by historical standards. In the near term, inflation will moderate on the back of lower energy prices. The main factors behind a subsequent increase are higher energy and food prices pulling up core inflation.

The benign inflation outlook implies that EM central banks will be able to raise monetary policy rates gradually in 2018 and 2019. Over the forecast period, we expect only China’s central bank to ease monetary policy by cutting banks’ Reserve Requirement Ratios (RRR). Turkey may also ease monetary policy, but it will depend on if the government carries out promised reforms to reduce underlying external imbalances, and if global investor risk appetite recovers. Russia’s central bank may also ease policy by the end of 2019, if the VAT hike in January causes domestic demand to weaken enough to prevent inflation from accelerating.

Commodities pressured by slowdown in China

We expect commodity prices to remain under pressure during the forecast period. China is likely to boost infrastructure investment to support overall growth, but will try to keep a lid on property construction to prevent speculative behaviour. Infrastructure investments are less dependent on commodities imports, which will hold back price increases.


Oil — OPEC+ can and will cut production if needed

• Russia and Saudi Arabia differ on oil price.

• But they agree on the need to prevent inventories

outside the US from rising again.

• We stick to our $85/bbl oil price forecast for 2019,

boosted by an expected agreement to limit output.

Since early October, the price of Brent crude oil has fallen by more than 30% from $86/bbl to $59/bbl at the time of writing. A large part of this decline has been centred on the very front end of the forward curve. This is the part of the curve where investors typically are short or long. Since late September investors have reduced their net long positions from 1.1 billion barrels of crude to 650 million barrels, or a 40% reduction.

First and foremost this has taken out the “premium” in the front-end crude prices versus longer-dated prices. In early October the premium for the front month contract versus the 5-year contract stood at $17/bbl while it is now only $0.5/bbl. The longer dated 5-year contract has also declined, but only by 7.5%, way less than the front-end contract. As a result the forward crude curves have flattened almost completely.

Investors started to lose heart already in April/May this year when it became clear that OPEC+ would ease production cuts in 2H-2018. Net long speculative positions in Brent and WTI crude then started to decline from a peak of 1.4 billion barrels in April. The spirit of global financial markets as captured by the S&P 500 index did however continue in an optimistic spirit as it moved higher from April to early October. In early October however the “animal spirits” left the S&P 500 index high and dry. Exit! Throw growth, oil and tech stocks over board. Shift into defensives.

Oil fundamentals clearly eased a little at the same time. More supply (US, Russia, Libya), softer Iran sanctions than expected, and a little softer demand outlook brought the oil

market back from the brink of overly tight conditions in 2H-2018 and 2019. The killing of Jamal Khashoggi also placed Saudi Arabia in a tricky position versus President Trump, who has been calling for increased production to lower prices.

Weighing it all together in hind sight it looks like the main driving force behind the large Brent crude oil sell-off is the change of mind among investors as they have shifted from growth optimism to defensive positions thus throwing growth and oil out the door. It is very notable that both the S&P 500 index and crude oil prices started to sell-off strongly at the start of October.

OPEC+ will not allow global inventories to rise

OPEC and its 10 cooperating countries meet in Vienna to discuss the global oil market balance on 6 December. The group has successfully managed to push down bloated global oil inventories towards normal levels over the past two years. We think that all the participants in the OPEC+ group of countries have one goal in common: Avoid global oil inventories from rising back up again in 2019. Oil producers in general hate high oil inventories since it drives crude oil spot prices below the longer dated price contracts, that is, it forces them to sell their oil at a discount to longer dated oil prices.

We think that producers within the group are both willing and able to hold back production in 2019 in order to prevent global inventories from rising back up again. In perspective Saudi Arabia produced 10.7 million bbl/d in October which is the highest level ever. In other words, it can easily reduce production by half a million bbl/d or more if needed. It has the ability to cut.

OPEC’s Secretary General, Mohammad Barkindo, recently stated: “OPEC and non-OPEC countries are committed to continuing to ensure that the market balance they have fought very hard for in the last two years is sustained.” That means preventing oil inventories from rising back up again in


2019 which again implies holding back production to some degree. We think that it is well within the capability of OPEC+ to hold back supply as needed in 2019. Our strong view is that OPEC+ will decide to limit production to prevent global inventories from rising back up again in 2019, and that they will communicate this clearly, potentially already after the December meeting.

At the moment the market is trading as if there will be no limits to supply from OPEC+ in 2019. That the oil market will run a surplus with rising inventories and with crude oil spot prices trading at a significant discount to longer dated contracts. Such a scenario would imply that the oil price needs to move down to a level where it induces a slowdown in US shale oil production growth on the one hand and stimulates global oil demand on the other hand. At the moment the local Permian crude oil price is already trading at only USD 48/bl.

Spectacular US production growth offset by declines elsewhere and demand growth

By December 2018, US crude and hydrocarbon liquids production will have increased by 4.2 million bbl/d since the beginning of 2017. That is indeed extraordinary. Global demand in comparison has only increased by 3.0 million bbl/d over the same period. What is lost in this picture is that over the same period, more than 2.1 million bbl/d in supply from other sources have been lost (Mexico, China, Venezuela, Iran, Azerbaijan and Angola) due to geopolitics and economics.

Upstream oil and gas investments have declined by 50% over the four years from 2014 to 2017. The effect of these investment cuts have already been partially felt in the above-mentioned supply losses of at least 2.1 million bbl/d. As we see it though, there is typically a 5 year lag from the initiation of investment cuts before a decline in production can be observed due to the long lead-time of conventional oil investments. The most significant effects of the investment cuts are thus probably still ahead of us.

We expect US hydrocarbon liquids production growth to be strong in the years ahead. We do however also expect that this supply growth is countered by growing oil demand as

well as supply losses in other places due to the deep investment cuts over the past 4–5 years.

But first we expect OPEC+ to signal clearly to the market on Dec 6/7 that they will manage supply in 2019 as needed to avoid rising global oil inventories.


USA — What if growth slows abruptly?

The US economy continues to perform strongly and so far there are few signs of sharp deceleration. We expect economic activity to slow only gradually in 2019 and 2020. This scenario should be manageable for emerging market economies. However, a much more abrupt slowdown in US growth is non-negligible risk. In this article we discuss the implication for emerging markets.

Our main scenario for the US economy

GDP growth has been well above the Fed’s estimate of potential growth of 1.8% for six consecutive quarters. In the second and third quarters this year, growth was 4.2 and 3.5% respectively. This pace of growth is unsustainable. Our main scenario for the US economy (SEB’s Nordic Outlook November) sees growth slowing gradually over the coming quarters due to a combination of factors. The Fed’s tightening of monetary policy is set to continue. We expect hikes in December, March and June, bringing the federal funds rate to 3.00% by the middle of 2019. Rising interest rates have already started to impact rate-sensitive parts of the economy, such as the housing market. Households are affected mainly through higher mortgage rates.

Higher interest rates have also contributed to a dollar appreciation. The dollar has strengthened significantly in trade-weighted terms and net exports are not expected to be an economic driver going forward. In our main scenario, disruptions from higher import tariffs and simmering trade wars will be a drag on capital spending as a small share of corporates postpone or reduce capital spending, but it will not have a major impact on the US economy. As expected, the November 6 midterm elections resulted in a divided Congress, with the Democrats taking control of the House of Representatives. This means that the Trump administration’s manoeuvring room will shrink and a new round of tax cuts should be off the table.

Alternative scenario: a sharper slowdown

Activity in the US economy could decelerate more sharply compared to our main scenario. The weak outcome for capital spending in the third quarter is a case in point. Business investment slowed and residential investment continued to fall. This happened despite the recent corporate tax cut and depreciation allowances. Surveys indicate US firms are worried about trade tensions. There is so far little evidence in hard data that trade policy has impacted actual capital spending but the soft third quarter data could be a warning of things to come.

Interest rates We may have underestimated the negative impact of rising interest rates on capital spending. Also, our main scenario sees only a modest rise in US yields from current levels. Our forecast is that the yield on US 10-year bonds will rise from the current level slightly above 3.00% to 3.50% by the end of 2019. However, as we saw in late January/February and more recently in October, yields can rise quickly and it is possible we are too sanguine about the impact of higher yields on economic activity.

Trade policy In our main scenario, we expect trade tensions to have only a minor negative impact on the US economy. However, tensions could easily escalate if the meeting between President Trump and president Xi at the G20 summit on November30/December 1 is a failure and the US also decides to impose tariffs on vehicle imports. The decision on whether to move forward on vehicle tariffs was recently postponed but is likely to be back on the agenda before long. A sharp escalation in trade tensions would impact US corporate’s decisions on capital spending. Consumer confidence would likely also take a hit.

Labour market There is substantial uncertainty regarding the extent of tightness in the US labour market and we could be overestimating the amount of spare capacity. There are already signs of bottlenecks and the strong employment growth seen in 2018 could slow down, causing private consumption growth to decelerate more sharply compared to our main scenario.

The combination of weakening capital spending and lower private consumption prompted by rising interest rates and an escalation in trade tensions could cause GDP growth to slow to 1.5% or lower in 2019. This would entail a sharp slowdown from the current high pace of growth.

Effect on emerging markets

How would emerging market economies be affected by a US growth slowdown? The gradual deceleration towards 2% over the next two years described in our main scenario


would likely have a small effect. However, a sharper slowdown would have a large negative effect.

Despite their rising influence, EM economies are still affected by growth in the US and other developed economies. Measured in purchasing power parities (PPP), EM economies account for nearly 60% of the world economy. However, this metric tends to exaggerate the importance of the EM sphere. When using nominal USD instead of PPP, the OECD countries still account for 60% of the global economy. The importance of the US is magnified by its dominant role in the global financial system. This means that US recessions spread and become global recessions. Indeed, comparing growth in EM and DM, EM growth only really decoupled in the 00-ties. Arguably the most important explanation was the integration of China and the emerging economies in Eastern Europe into the global economy that provided a temporary boost to EM growth.

There are several channels through which EM economies would be affected by a US slowdown.

Trade flows Slower US growth would decrease the demand for imports, including imports from emerging markets. The dependence on exports to the US differs widely between individual EM economies. Mexico is the economy most dependent on US demand, sending around 80% of its exports to the US. China is the largest exporter to the US. However, at present Chinese exports to the US are more driven by tariff and trade policy developments than the US business cycle and a downturn in growth.

US equity markets In the alternative scenario, the growth slowdown would have a negative impact on US equity markets. US profit margins are historically high and a sharp slowdown in economic activity is likely to result in earnings disappointments putting downward pressure on equities. As we have seen in 2018, falling US stock prices have spread to EM stock markets and we expect a more marked growth deceleration to have a negative impact on emerging market equities. However, the wealth effect (a decline in household wealth tends to decrease household consumption) is weak in most emerging market economies meaning stock market downturns would have little impact on private consumption and GDP growth.

Softer Fed policy and weaker USD would support EM The impact on emerging market economies of weakening US growth is further complicated by the bearing it would have on the Fed’s monetary policy. A sharper slowdown in H1 2019 could force the Fed to reconsider its rate hikes putting a halt to its tightening after the December hike. The combination of a more marked slowdown in economic activity and a more dovish outlook for monetary policy would put some downward pressure on the USD. A weaker USD would benefit many EM economies. Exports priced in USD would become more competitive. Debt financing of USD denominated loans would be less expensive and problems of capital outflows would be mitigated. USD-weakening would therefore soften the negative impact of a sharper deceleration.

In sum, although growth in emerging markets has not decoupled from growth in the US, a sharper slowdown for economic activity would have a negative impact on EM GDP growth. In a scenario where US GDP growth decelerates sharply to 1.5% in 2019, economic activity in EM would slow too, possibly down to around 4%, compared to our main scenario of growth slightly below 5%.


China — Spotlight on imports

• Despite higher US tariffs, China’s exports continue to

beat market expectations.

• A recent surge in imports implies sustained

improvement in investment.

• Changing consumption patterns, not headline GDP

growth, will drive global trade.

• Ongoing vertical integration has led to less reliance on

intermediate and capital imports.

• Imports of commodities and consumer goods are

increasing due to a rebalancing of China’s economy.

Trade surprises on the upside

Even as the second tranche of US tariffs was implemented in late Q3, exports in October beat market forecasts with a rise of 15.6% y/y. Persistent front-loading of shipments in anticipation of further tariffs early next year lend short-term support to exports. However, it is the surge of imports by 21.4% y/y that we find more interesting. Strong growth rates in import volumes of unwrought copper, coal, and iron ore indicate sustained improvement in domestic demand, particularly investment. We have been of the view that the coordinated and targeted response of the authorities has focused on stabilizing growth, rather than eliciting a rebound. We expect larger investments in manufacturing and real estate to provide an offset to soft infrastructure numbers, steadying headline growth in fixed investments.

Rebalancing will propel global growth

In this note, we look at the evolution of China’s import basket in the last 15 years. China’s rebalancing implies that Chinese consumption pattern (more than its GDP) will increasingly propel global growth via the trade channel. In the last several years, China has slowly increased its demand for imports, absorbing 8.7% of world shipments in 2017, up from 3.0% in 2002. At the same time, the composition of imports has also evolved.

China: Imports by product cluster 2017

Whereas capital and intermediate imports used to account for almost 78% of China’s imports in 2002, a push for vertical integration of the domestic supply chain has slowly lowered the share of these product categories to less than 60% by end-2017. Meanwhile, imports of raw materials have doubled their share to 25.9% in the last 15 years.

The distributional effects of this trade spillover have also changed the landscape on a country level. The rise of imports of raw materials led to deeper trade relations with Australia. The “Land Down Under” now accounts for 5.6% of China’s total imports from less than 2% in 2002. Conversely, less reliance on intermediate goods partly explains the decline in the share of Japan as a source of imported goods to 9.7% from less than 20% over the same period.

Exports to China percent of total exports

China’s ascent in the last few decades points to greater influence on its partners’ trade outlook. In terms of relative exposure to Chinese demand, Australia and South Korea top the list. Australia ships 30% of its goods exports to China, the highest share of all countries. South Korea sends almost a quarter of its exports to China.

Australia’s exports to China

However, the composition of China’s imports from these two countries differs remarkably. Raw materials comprise more than three-quarters of Australia’s shipments to China, while

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two-thirds of South Korea’s exports to China are made up of capital goods. A continued integration of China’s supply chain will likely lead to a further decline of capital goods imports, presenting long-term downside risks for South Korea’s exports.

Consumer imports are gaining ground on the back of a gradual shift towards domestic demand. As a share of China’s import bill, the shares of US and Germany have remained broadly stable at 9% and 6% respectively in the last 15 years. Yet, China’s increasing demand for consumer goods have shifted progressively towards more advanced economies. Specifically, the share of consumer goods exports from the US and Germany to China have doubled as a share of these countries’ exports since 2002, even as the share declined for most countries in Emerging Asia. In Germany’s case, the pace of growth in consumer goods exports to China picked up after the Global Financial Crisis, expanding to almost 28% of German exports to China. Meanwhile, the rise in the share of consumer exports from the US has been slower, rising to 20% from 9% of US exports to China in 2002. Simply put, Chinese consumers increasingly prefer consumer goods from the West over the rest of Asia.

Rising share of consumer goods imports

Looking forward, while China’s growth will likely moderate due to its structural rebalancing, the evolution of Chinese consumption will drive global trade. In the short run, stabilization in fixed asset investment will likely prop up imports of raw materials. Yet, in the long run, sustained vertical integration should lead to progressively lower imports of capital and intermediate goods. For now, the outlook for consumer goods imports is increasingly oriented towards the West. It remains to be seen whether the intensifying trade war will have a significant effect in shifting Chinese consumption patterns.

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India — Markets swinging with oil prices

The Indian rupee and the Sensex equity index have both lost roughly 10% in 2018. Real GDP is growing strongly, which together with lower oil prices in the near term and tight monetary policy, will help stabilise markets. Unpopular reforms of the labour market and regulations surrounding land purchases will be on hold until after next year’s elections. However, reforms will be necessary if the government will succeed in keeping growth around 7% per year beyond 2019.

Strong growth outlook

India’s economic growth in 2018 have taken most by surprise, not least the real GDP expansion of 8.2% y/y in the second quarter which was the fastest in two years, and higher than most other emerging markets. Strengthening domestic demand and a reduced drag from net exports contributed to the acceleration. Moreover, the headwinds generated by the Goods and Services Tax (GST) and the monetary reform (“demonetisation”) have dissipated. This being said, quarterly growth rates have declined in the past few quarters and our view is that activity will moderate slightly over the next few quarters. This has indeed been the case already in some other major emerging economies, including China. Monthly indicators have been somewhat mixed in India however. For example, while manufacturing business sentiment recovered to 53.1 in October, well into expansionary territory, the expectations component, also in the services index, hit new lows. We forecast real GDP to expand by 7.8% in 2018 and 7.6% in 2019, fuelled by strong domestic demand. This rate would put India among the top expanding economies globally.

High dependence on imported oil

The swings in global oil markets have been large this year and have served as a reminder of one of India’s key vulnerabilities — its large dependence on oil imports. India is the world’s third largest oil importer and expectations are that they could overtake both China and the US in a not too distant future. Although the government has taken steps to

increase domestic production, the country imports roughly 80% of its oil needs. The near tripling of crude oil prices in the past two years have driven up India’s import bill and thereby contributed to widening the current account deficit. The larger deficit in turn puts downward pressure on the exchange rate which increases the cost of imports even further. In addition, higher oil prices drive up the government’s costs for petroleum subsidies. The oil price rise led forecasters to revise their FX forecasts lower and raise their forecasts for the current account deficit. The past month’s sudden plunge in oil prices was understandably greeted by a cheer in financial markets and, if sustained, may give reason to revise some of these changes.

How serious for the INR?

The current account deficit widened to 2.4% of GDP in 2Q 2018 driven by strong imports. As foreign direct investment (FDI) has been moderate, the country’s basic balance (current account and FDI) has been parked in negative territory since early this year. The deficit is one of the underlying factors putting pressure on the rupee exchange rate, which fell to historical lows versus the US dollar in October. Having previously prided itself with a strong rupee, the authorities responded to the weakening and to the rising current account deficit by adopting measures to encourage capital inflows. The measures included stimulating foreign investment in the domestic bond market and making it cheaper for companies to borrow from abroad. In addition, import curbs were introduced, raising India’s already high trade barriers. Helped by a lower oil price, the rupee has recouped some of the losses versus the US dollar, but it is still down 10% since the start of the year. The drop has caused black headlines, but it has also reduced some of the overvaluation that had built up in the previous years, at least in terms of the real effective (trade weighted) exchange rate which is now only marginally weaker than its 10-year average level. The INR is likely to hold ground in 2019 supported by lower oil prices and relatively high carry.


Monetary policy on hold, but more to come

Brisk growth and rising crude prices boosted inflation to levels above the central bank’s 4.0% inflation target in the first half of 2018. Since mid-2018, consumer prices have been declining but we still see inflation averaging 4.3% for the calendar year. With inflation above target during a significant part of the year, the Reserve Bank of India (RBI) responded by raising interest rates twice in mid-2018 to 6.50%. At its October meeting, it paused and lowered its inflation forecasts. Indeed, the recent plunge in global oil prices should reduce some of the upward price pressure. Still, the RBI forecasts steadily rising inflation through 2019. We expect two more rate hikes by the end of 2Q 2019 to bring the repo rate to 7.00%. In the past, rising inflation has tended to contribute to voters turning against the sitting government. While the Modi administration is pressuring the RBI on other issues, it is probably content letting the RBI continue its relatively successful inflation-targeting policy.

Slowing pace of fiscal consolidation

While monetary policy has been tightened, fiscal consolidation slowed in the past fiscal year. Lower than expected revenues generated a small rise in the general government budget deficit to about 7% of GDP. Following

various measures to lessen the blow of high energy prices on consumers, the government subsequently lowered their ambitions for consolidating government finances in the near-term. The budget for fiscal year (FY) 2018/2019 (ending in March 2019) still envisages a narrowing of the central government’s deficit to 3.3% of GDP. However, cuts in petrol and gasoline duties and indications that revenues may be lower than expected mean that there is a risk that the deficit target is missed. In addition, fiscal pressures are likely to rise as elections approach in 2019. Persistent fiscal deficits over the years have pushed up government debt to a high level. General government debt reached an estimated 70% of GDP in FY 2017/2018. Together with persistently large negative government balances, public sector indebtedness is the single most important concern of the rating agencies.

Banking sector creates new headaches

A poorly performing banking sector has long been a dark cloud hanging over the economy. With balance sheets burdened with bad loans, banks have been reluctant to lend which together with weak corporate balance sheets have produced meagre credit growth. Changes in the sector have taken place at a glacial pace and rarely caught the attention of markets. However, concerns about financial stability rocked markets in connection with the default of Infrastructure Leasing & Financial Services Limited (IL&FS) — one of the country’s many shadow banks, or non-bank financial institutions (NBFI). The role and market share of India’s NBFIs have risen in the past years. Hence, fears that the IL&FS’s problems (chiefly asset-liability maturity mismatches) would show up also in other NBFIs caused short-term borrowing costs to rise and spreads to widen. Liquidity conditions have remained tight and credit extended by these institutions has fallen markedly since then. While one could envisage a scenario were credit supply from the NBFIs and banks (which often own or lend to the NBFIs) would plunge and thereby squeeze spending and investment in the near-term, we expect that the stress in the NBFI sector will not cause broader systemic problems. The RBI’s handling of the situation has led to rising tensions between RBI and the government. The government has criticized the RBI for several alleged policy missteps. However, while the central bank’s intention is to improve macro-prudential regulation of lenders, the government is eager for all kinds of measures that would boost short-term liquidity. The government may make additional attempts to limit the independence of RBI, but we think that the risk of actual curbs on its monetary-policy autonomy is low.

Elections approaching

Elections to the country’s lower house are due in 2019, likely in April or May. Prime Minister Modi’s Bharatiya Janata Party (BJP) is generally considered the front runner. Although they are likely to secure a second term, there is a significant risk that they will lose their majority which would make it necessary to rely on coalition partners to retain power. The election campaign is expected to draw on Hindu-nationalist rhetoric which will raise the risk of political violence. A hint of whether or not the former party of power, the Congress party, will be able to challenge Modi in next year’s elections


might come in three state elections taking place in November and December 2018. The outcomes of these three elections are also likely to shape the election campaign in early 2019.

Bright longer-term outlook

India’s medium-term growth prospects are bright. GDP per capita is rising more rapidly than in countries such as Mexico and Brazil. The level of income is still significantly lower, however, indicating there should be ample room for catching up. In the next several decades, India’s well known demographic dividend will be one important ingredient in supporting high growth rates while many other emerging markets will see declining labour supply. Furthermore, although the appetite for new structural reforms is likely to be low in the run-up to the elections, reforms expected after the elections should raise productivity and help to drive the convergence with the developed economies. Key areas that are still in need of major reforms include the labour market and issues related to land purchases. The IMF recently calculated India’s potential output growth to 7.75% and noted that there is considerable scope for raising this to above 8.0%.

India’s improving growth prospects is reflected in various measures of the country’s business climate and competitiveness. For example, the country’s ranking in the World Bank’s Doing Business Index has improved steadily in the past couple of years following a targeted effort by the authorities. In this year’s ranking India advanced 23 spots in the rankings, to 77th place, up from 134th in 2015. However, the country is still lagging several important emerging markets, including China, Indonesia and Mexico. Another example is India’s 58th ranking (of 140 countries) in the World Economic Forum’s Global Competitiveness Index this year. It represents only a small improvement from 2017, reflecting the relatively slow reform progress recently. India leads emerging markets such as Turkey and Brazil but trails countries such as Mexico and Russia.


Country Section

Asia

China We expect GDP growth to be 6.6% in 2018 before it moderates to 6.3% and 6.1% in 2019 and 2020 respectively. The slowdown is due to both structural and cyclical issues. Structurally, the authorities’ commitment to rebalance growth drivers suggests that the rate of expansion was already expected to pull back from the 6.5-7.0% range to a more moderate pace of 6.0-6.5% in the medium term.

The latest GDP print of 6.5% y/y in Q3 (6.7% ytd y/y) implies that the trade war has had limited impact on actual activity thus far. Considering that net trade has contributed an average of -0.1ppts to headline growth in the last five years, China’s growth engine is domestic. Thus, we have been of the view that the effect of the trade war has been overestimated this year.

Much more than the trade tensions, weak domestic investment has weighed on industrial activity. Indeed, the continued contraction in infrastructure spending, which accounts for more than 22% of investment, implies that the authorities’ push for structural rebalancing remains in play. In light of the financial risks posed by the unregulated surge in credit growth in the past, we do not see the Chinese government easily abandoning their policy of deleveraging. Instead, we expect more targeted incentives to boost financing through the formal sector even as controls on shadow banking activities continue to tighten.

Even so, the trade war has had a negative impact on confidence which has resulted in persistent downward pressures on the CNY and equity market. Since the start of the year, listed enterprises have lost more than 20% of their market value. Meanwhile, the CNY remains perilously close to the psychological level of 7 against the greenback. The

risk of a prolonged “confidence shock” is now evolving as a larger threat than the direct effect of a trade war.

In response, a chorus of Chinese officials and the central bank rolled out a coordinated programme to support domestic demand. Yet the targeted approach taken by Beijing suggests that the aim is to stabilise growth, rather than to trigger a rebound. The central bank has introduced incentives to prop up bank credit to private enterprises. Meanwhile, the authorities have encouraged local government backed funds to support share pledges in a bid to stem the decline in equities. More tax cuts will likely be rolled out in 2019, which should support private spending. In our view, risks related to debt sustainability will keep policy focused on boosting private spending through targeted reduction in fiscal revenues.

In line with targeted easing in bank credit conditions, we expect another 50bps cut in banks’ reserve requirement ratio in Q1 2019 even as the central bank will keep its interest rates unchanged. With tighter interest rate differentials with the US, the currency is likely to remain within a tight range around 6.9 until end of 2018 with an expected recovery limited to 6.75 by end 2019.

Indonesia Average growth is likely to have remained at 5.1% in 2018, though the investment outlook will pull back growth to 5.0% in 2019 and 2020. Private consumption, which accounts for 54% of total activity, remains a bulwark of stability.

Real investment has also been resilient contributing an average of 2.2ppts every quarter since the start of 2018. However, the authorities’ focus on limiting the current account deficit will lead to some delays in investment in the coming quarters. The government has also introduced higher tariffs on selected consumer goods. Overall, the coordinated efforts of the authorities to manage the external imbalances should dampen domestic demand in 2019 and 2020.


Meanwhile, monthly trade balances have been predominantly negative in 2018, reversing the surplus last year. Export growth has already eased from its peak while import growth is still propped up by a higher oil import bill and investment-related imports. Although government policies have dampened the pace of growth of investment-related products such as capital imports and cement sales, the import bill has not dropped enough to turn the merchandise trade balance into a surplus. As such, net trade remained a drag on overall growth.

As of Q3 2018, the shortfall in the current account widened to USD8.8 billion (3.4%of GDP) from USD8.0 billion. Although foreign bond flows continue to come in, they have declined from levels posted last year. Furthermore, equity portfolio flows year to date have not yet recovered from the sell-off earlier this year.

Even as inflation remains in the lower half of Bank Indonesia’s (BI) 2.5-4.5% target range, the central bank’s focus on stabilising the rupiah will keep BI on a tightening path. Despite a recent recovery in the IDR, it remains the second worst performing Asian currency year to date, having weakened by more than 8%. As a result, the central bank aggressively raised the policy rate by a cumulative 175bps reaching 6.00% in a span of 6 months. BI continues to reiterate its focus on lowering the current account deficit and strengthening the attractiveness of domestic financial markets by anticipating the pullback in global liquidity in the coming months.

Even so, the fundamental sources of downward pressure on the IDR remain. So long as the Fed continues to tighten policy, the pressure on BI to raise interest rates further is strong. As such, we expect at least 50bps of hikes in 2019, while acknowledging risks for more aggressive moves if negative sentiment on EM intensifies. That said, we expect the IDR to approach 14,175 against the USD by end-2019.

Korea Growth continues to moderate and will likely average 2.6% in 2018 leading to further pull back to 2.5% in 2019. Downside risks are spreading and activity is likely to fall short of the central bank’s forecast of 2.7% for both 2018 and 2019. Real consumption is slowing down and the evolution in consumer sentiment points to more deterioration in the coming months. Employment conditions remain sluggish. Since the government aggressively raised its minimum wage in January 2018, the quality of employment generation has deteriorated with greater increases in temporary and daily workers compared to gains in regular employment.

Hamstrung by high base effects, facilities and construction investment was a drag on headline growth. Yet, sequential momentum is also waning as trade tensions have delayed capacity expansion. While planned public investment will provide some cushion through 2019, it is unlikely to “crowd in” private investment.

Exports have so far shrugged off trade tensions. However, with a quarter of shipments going to China, the slowdown in China is a significant risk.

In light of the downside risks, the government is expected to roll out a package of supportive measures aimed at generating jobs. However, recent data suggest that the government’s efforts have not been sufficient to offset the pressure from the wage adjustment. Furthermore, a fresh round of wage hikes of around 10% next year will keep the pressure on the labour market. Even so, the fiscal stance is hardly expansionary. The fiscal deficit is planned to marginally expand to 1.9% of GDP in 2019 from 1.8% in 2018. While supplementary budgets have been utilised in the past, we don’t expect the authorities to be aggressive in propping up growth.

That said, Bank of Korea will be required to maintain a supportive stance, with a first hike coming in Q4 2019. Although risks related to high household debt remains, the downside risks to growth do not justify higher interest rates for now. Instead, more macro-prudential measures focussed on the mortgage market may be expected.

Nevertheless, the surplus in the current account is likely to remain around 4.5–5.0% of GDP in 2019. Foreign flows in the local bond market have also added support to the Korean won. We expect USD/KRW to be 1,075 by end 2019.

Malaysia We expect real GDP growth to average 5.0% y/y in 2018 before it moderates further to 4.8% in 2019 and in 2020. Domestically, private consumption has been and will remain a major driver of growth. The sharp improvement in consumer sentiment after Prime Minister Mahathir Mohamad regained power has kept private consumption supported. The removal of the Goods and Services Tax (GST) in Q3 2018 provided a temporary boost to household spending, though this will partly be offset by the introduction of the Sales and Service Tax (SST).

Investment contracted in the first half of 2018 and became a major drag on growth. This was due to tightened credit conditions, together with policy uncertainty following the change of government. Public consumption also declined. Externally, export growth got some support at the start of the year from global economic expansion. However, global growth is expected to moderate, with advanced economies gradually tighten their monetary policies.


Looking forward, PM Mahathir’s focus on reducing overall liabilities will limit the government’s fiscal space to support growth. In recognition of a large share of debt with explicit government guarantees, the 2018 budget deficit at 3.7% of GDP came in well above the initial target of 2.8% of GDP. Further, the recently released Budget 2019 suggests that the overall fiscal environment will be tough. A weaker revenue forecast has not been met with a proportional cut in spending. Instead, the government will rely more heavily on petroleum revenues, which would be exposed to fluctuations in global oil prices. Fiscal consolidation has effectively been pushed back. The government aims to consolidate its books targeting deficits of 3.4% in 2019, 3.0% in 2020 and subsequently to 2.8% in 2021. Its medium term goal is to reduce the deficit to 2%.

Inflation will stay low this year, but pick up in 2019. Headline inflation has stayed below 1% in the last four months, reflecting the removal of the GST. With low base effects and the introduction of the SST, inflation will gradually pick up next year. Global oil prices are also projected to move up further in 2019, which will contribute to higher inflation.

Interest rates will be stable in 1H 2019 and a 25bps hike is expected in the second half. Bank Negara Malaysia (BNM) has kept its benchmark rate unchanged at 3.25% since hiking by 25bps in January 2018. With the domestic economy continuing to face downside risks and inflation staying low, the central bank is unlikely to tighten in the first half of 2019. However, the central bank will restart the hiking cycle in the second half with rising inflation.

MYR has been relatively resilient compared with other Asian currencies despite external headwinds this year, thanks to Malaysia’s large current account surplus. MYR will end 2018 at 4.15 and appreciate slightly to 3.99 by end 2019.

Philippines We expect GDP growth at 6.3% in 2018 before it moderates to 6.2% and 6.1% in 2019 and 2020 respectively. Despite some moderation in growth, domestic demand remains robust. The pullback in headline growth was mainly due to a widening drag from trade. Fixed investment remains a key support, having risen 16.5% y/y in Q3. Government consumption also had a strong print at 14.3%. Conversely,

private consumption, which accounts for almost 70% of GDP, slowed for a second quarter to 5.2% from 5.9%.

The government’s infrastructure drive shows no sign of easing. While the fiscal deficit is unlikely to breach the planned ceiling of 3% in 2018, the pro-cyclical stance of the authorities is at the heart of the expected decline in primary balance. Considering the strong momentum in private spending, the IMF suggests a more neutral fiscal position with target deficits lowered to 2.4% in 2018 and 2.5% in 2019, compared to the government’s forecast of 2.8% and 3.2% respectively. Next year, the government plans to suspend the second round of increases in oil taxes, scheduled to be levied in January 2019. The foregone revenues are estimated at PHP26 billion (~0.1% of GDP). In our view, the government will likely lower spending to offset the loss, instead of running a wider fiscal shortfall.

Although credit growth has eased to 17.4%, the credit impulse is still strong. Fiscal expansion and strong private sector demand have kept trade deficit wide, pushing the monthly average trade deficit to USD 3.3 billion year to date, a marked widening from the average monthly of USD 1.9 billion during the same period in 2017. Even with a rising flow of remittances from overseas Filipinos of around USD 2.8billion each month, the shortfall in the current account persists. Some relief in the external basic balance is coming in the form of strong FDI which has yielded USD7.4 billion in the first 8 months of the year. However, so long as domestic demand is running on all cylinders, the current account deficit will remain in 2019. This shortfall should keep PHP under pressure, trading around 54.0 by end 2018 and crawl towards 51.8 by end 2019.

Meanwhile, demand pull price pressures are still elevated. Although inflation has likely peaked at 5.3% y/y in 2018, we expect the pace in price gains to remain high at 4.2% in 2019, still breaching the central bank’s 2-4% inflation target range. The central bank has already embarked on an aggressive tightening cycle raising its policy rate by a cumulative 175 bps in the last 6 months. Yet, the effect of monetary tightening will be dampened by the expansionary stance of the government. Against this backdrop, we expect the central bank to maintain its hawkish stance until inflation expectations are anchored.


Singapore We now expect GDP to rise by 3.4% in 2018, before moderating to 2.9% and 2.6% in 2019 and 2020 respectively. While advanced estimates of Q3 GDP printed on the soft side at 2.6% y/y, this largely reflects unfavourable base effects. On a sequential basis, total output rose 4.7% q/q saar, which remains above-trend. Considering the momentum in high frequency indicators, headline growth will likely be in the upper half of the central bank’s 2.5-3.5% forecast range.

We expect a construction-led improvement in domestic demand. Despite the introduction of another round of cooling measures on the property market in in July, real estate indicators are robust. The strong pipeline in building plan approvals assures that the outlook on fixed investment remains sanguine. The government has also planned enough infrastructure investments in transport, health and communications to boost activity in the coming years.

In October, the Monetary Authority of Singapore (MAS) tightened its policy again. The NEER slope was increased slightly to an estimated 1.0% per annum up from 0.5% in April. In our view, further policy normalisation remains in the cards. We expect another round of policy tightening from the central bank in April 2019. Although the MAS recognized the downside risks related to the trade war, the central bank is of the view that the trade tensions are a multi-year phenomenon. Thus, its effects on Singapore’s growth outlook in the next 12 months are unlikely to be sufficiently apparent for MAS to incorporate in their baseline forecasts.

Even with the moderation in headline growth, a small output gap will remain in 2019. The MAS continues to expect upward pressure on domestic inflation, continued improvement in the labour market. The central bank’s measure of the core inflation is already at 1.8% y/y as of August and is positioned to rise further by year end. The MAS expects core inflation to average around 1.5–2.5% in 2019 with the peak occurring in H1. Historically, the S$NEER tended to approach the upper bound of the currency band when core inflation prints were around the 1.5–2.5% range. With further tightening still on the horizon, we expect SGD to remain a regional outperformer as it approaches 1.33 against the dollar by end-2019.

Thailand We expect GDP to rise by 4.5% in 2018, before moderating in 2019 and 2020. Although intensifying trade wars will put a dampener on external goods trade, domestic demand looks strong. Private consumption is on an upward trend, though its rate of expansion is capped by persistently high household debt. The public sector continues to drive investment, though the improvement in private participation also provided some boost in 2018. However, government spending is expected to grow a touch lower than initially expected in light of delayed implementation by some state-owned enterprises.

On the external front, export growth is moderating on the back rising trade protectionism and weaker demand for electronics. On the other hand, imports remain robust from a deepening improvement in the investment cycle and household spending. Meanwhile, the rate of expansion of tourist arrivals has also declined due to a lower number of Chinese tourists in 2018, following the Phuket boat accident in July. However, booking rates suggests that trips have only been pushed back and will likely see a return on Chinese tourists in 2019.

Overall, the external position remains in a sizeable surplus despite the decline since 2017. As of October, the current account stood above 10% of GDP, providing enough buffer for the THB against the tide of negative sentiment on the EM space. We expect the baht to appreciate against the greenback, moving to 31.0 by the end of 2019.

The Bank of Thailand (BoT) has started to sing a different tune. On its latest meeting in November, four out of seven members of the Monetary Policy Committee (MPC) voted to maintain its policy rate at 1.50%, while three voted for a 25bps hike. Although headline inflation will likely remain in the lower half of BoT’s target range in 2019 and 2020, the economy is gaining traction. In an increasingly hawkish tone, the central bank indicated that the need to keep the policy rate low has been “reduced.” BoT has been on an extended easing cycling since late 2011. In our view, the need to rebuild policy space along with managing risks related to financial stability will pave the way for policy normalisation to begin before the end of 2018.


Emerging Europe

Russia We expect the USD/RUB (now 65.50) to end the 2018 at 65.00. The RUB will strengthen on an expected increase in oil prices and a slight increase in investor risk appetite due to lower risk of additional sanctions by the US in the near term. In 2019, the RUB will weaken gradually due to higher inflation and a build-up of fiscal foreign currency reserves.

Real GDP growth slowed to 1.3% y/y in 3Q making it highly unlikely that the economy will grow more than 1.6% in 2018 as a whole even if 4th quarter reaches an expected 2.0% y/y on the back of higher oil production. Household consumption has been the main driver of growth, holding up well thanks to lower unemployment and lower inflation. The weakness in the RUB has lowered imports making trade a net contributor to growth in 2Q 2018. With a statist approach to macro-economic policy and concerns lingering over existing and potential future sanctions, investments have been lagging. Deep structural reforms are unlikely, which will leave potential growth at around 2.0% over the coming years. We expect growth to reach 1.6% in 2019, held back by a VAT hike to 20% from 18%.

Inflation has increased gradually reaching 3.5% y/y in October 2018 after touching a low of 2.2% in early 2018. Inflation will rise partly because of a weaker RUB, higher wages and reduced slack in the economy, and partly because of the VAT hike. The Central bank of Russia (CBR) has the political room to manoeuver to tighten policy, but we expect inflation to rise above the 4.0% target to average 4.6% in 2019. The policy rate, currently at 7.50%, looks set to reach 8.00% in 2Q next year, with the risk to the forecast skewed towards higher rates.

The health of public finances is a key support for Russian markets. The government has cut real spending and increased revenue in response to the drop in oil prices 2014–2015 in order to avoid being dependent on investors, especially foreign investors. With oil prices surpassing projections, the federal government budget recorded a surplus of 2.1% of GDP in the first nine months of 2018

compared to a deficit of 1.2% during the same period in 2017. General government debt is low at 15%–17% of GDP. The government is forecasting a budget surplus 2019, which looks achievable. However, pressure on public finances will increase. Poverty is widespread and the infrastructure network is deficient. Pressure for spending increases will also come from President Putin’s development goals, which could undermine public finances. Yet, judging by recent history, if public finances were to deteriorate markedly, we expect the government to tighten policy enough to contain debt close to current levels.

The current account generated a surplus of more than 3% of GDP in the first nine months of 2018. Nevertheless, an increase in the CBR’s international reserves since 2015 has stalled in 2018 on concerns of additional sanctions being imposed on Russia by the US. Capital outflows in 3Q 2018 were the largest since 2015, pushing up Russian government 5-year yields from 6.5% in April to a peak of 8.9% in September. Nevertheless, fears of additional sanctions have eased after the US mid-term elections after both leading Democrats and Republicans have indicated that they will not have time to pass any before the end of the year. We expect capital flows to recover over the coming 3–6 months, which in turn will allow the RUB again to become more correlated with changes in the oil price and yields to fall gradually to between 7.0% and 7.5%.

Poland The Polish zloty is undervalued. Yet, we do not perceive a trigger that would cause a trend strengthening of the PLN. A rate hike would lift the PLN, but since the NBP is unlikely to move significantly before the ECB the effect will likely be temporary. We do not expect a hike in the policy rate before the middle of 2019, leaving EUR/PLN (now 4.30) trading in a range between 4.16 and 4.42. We believe that the PLN looks attractive when EUR/PLN is around 4.40.

Real GDP expanded by 5.2% y/y in the first 9 months of 2018 and looks on track to grow by 5.1% for the year. Investment has been growing, but the main driver of growth has been a rise in household consumption. Net exports have been slightly negative. However, growth has stalled in 2019. The manufacturing PMI moderated to 50.4 in October 2018,


while the sub-index for new orders fell to a 6-year low of 44.9. Also the PMI for future output has dropped to a 5-year low. We expect growth to slow to 3.5% in 2019 on weakening external demand. Domestic demand growth also looks set to slow due to capacity constraints in the labour market and rising inflation.

Given the tightness of the labour market, inflation has been low, averaging only 1.8% y/y in the first ten months of 2018, well below the 2.5% target, albeit within the 1.5%–3.5% tolerance band. Nevertheless, the economy is operating at near full capacity, which should push up inflation to around 3.0%. The National Bank of Poland (NBP) recently raised its inflation forecast to 3.2% for 2019 (from 2.7%), due to an expected hike in electricity prices. While a big hike in electricity tariffs ahead of parliamentary elections (no later than November 2019) are unlikely, the NBP is potentially facing a slowdown in economic growth and rising inflation next year. The NBP is unlikely to hike rates if they think that the rise in inflation above target is temporary. The NPB’s next forecast in March next year will provide an important clue to their thinking.

Government finances have been boosted by strong growth and improvements in tax and VAT collection, narrowing the budget deficit to less than 1% of GDP in 2018 and lowering government debt to an estimated 49% of GDP (EU metho-dology). The resilience of public finances will be tested next year if growth slows as projected while the cost of the government’s social benefits programmes remain the same or even increase due to unfavourable demographics. In addition, the ruling Law and Justice Party (PiS) performed worse than expected in local elections in October and will likely boost spending before parliamentary elections next year. However, even if the government is unsuccessful in reducing government debt further as planned, public finances are unlikely to become a significant drag on markets in the coming year.

Government bond yields (10-year) are currently around 3.2%, and will likely range between 3.0% and 3.5% in the next 3–6 months. The yields are relatively high compared to Czech Republic reflecting a higher government funding need. Increasing political risk has also contributed to relatively high Polish yields. However, local political developments have had a diminishing impact on Polish markets over the past year.

Turkey Booms and busts will continue to be defining features of Turkish markets for the foreseeable future. In the near term, markets will be in a recovery phase, temporarily pushing down USD/TRY (now 5.30) to as low as 5.10 in December 2018 or January 2019. However, we expect TRY to weaken again due to high inflation, leaving USD/TRY at around 5.80 at the end of 1Q 2019. The government will work to stabilise investor expectations on fiscal and monetary policy, which will help push down yields gradually. We expect the government’s benchmark 10-year yield to fall to around 18% in 1Q 2019 from the current 20%.

Turkey entered a recession in 3Q 2018 following a 45% fall in the TRY against the USD (between January 1 and August

13) and a sharp rise in interest rates that produced a sudden stop in domestic credit growth. Industrial production contracted by 3.2% y/y and bank lending by 4.0% m/m in September, the largest drop in lending since the 2001–2002 crisis. The fall will be cushioned by a reduction in Turkey’s trade deficit. Imports fell by 18.3% while exports rose by 22.4% in September. The drop in domestic demand generated the largest monthly current account surpluses on record in August and September. However, the contribution from net international trade will not be enough fully to offset the domestic contraction as high inflation and large import needs for the export sector will gradually reduce the competitiveness gain from the depreciation of the TRY. We expect real GDP growth to be 3.5% in 2018 and 1.0–1.5% in 2019. Our 2019 forecast is somewhat above consensus, as we expect fiscal stimulus ahead of local elections on March 31, 2019 to support growth.

Inflation reached 25.2% y/y in October 2018, the highest level in 15 years, driven primarily by the depreciation of the TRY. While the TRY has strengthened by some 25% since bottoming out in August, inflation expectations have risen, leaving the central bank forced to fight a prolonged battle to bring down inflation. We expect inflation to average 17% in 2018 and 20% in 2019, before moderating to 10% in 2020 due to weak domestic demand growth and relatively tight monetary policy. The central bank has an inflation target of 5.0%, but reacts more to changes in the TRY rate than the CPI. For now, risk appetite is too fragile for the central bank to cut its interest rates and we expect it to keep the policy rates on hold through the end of January 2019, when it will start to ease policy gradually.

Politics will play a determining role for Turkish markets. Relations with the US have improved. Turkey released an American pastor that was in house arrest on terrorism charges, while the US gave Turkey exemptions from sanctions on Iran. Further steps by both sides to reduce tensions are likely. The detente reduces the threat of sanctions and a sudden stop of portfolio flows covering Turkey’s large external financing need. In the run up to local elections scheduled for March 31, 2019, the government will try to boost the economy by increasing fiscal spending. In addition, it will maintain a tough stance versus Kurdish


nationalists in order to attract Turkish nationalist voters that are important not least in smaller communities. Turkish markets look set to enter a relatively calm period, allowing portfolio investors to benefit from high yields. Yet, the risk of an economic or political setback is large.

Czech Republic We expect the CZK to strengthen in the next 3–6 months pushing down EUR/CZK (now 26.0) to 25.5 on the back of tighter monetary policy and a near-term stabilisation of EM risk appetite. While the appreciation is relatively small, carry is positive and risk is relatively low, given that the Czech National Bank (CNB) is trying to strengthen the CZK.

Czech real GDP will slow to around 2.8% in 2018 from 4.3% in 2017. A moderation in external demand growth — due to slowing German exports and a drop in car production following the introduction of new EU emission standards in 2018 —is the key factor behind the deceleration in the export-dependent economy. While business confidence indicators remain very high, PMI readings have been falling since January 2018. Despite an expansionary fiscal policy and strong household consumption, we expect growth to moderate further in 2019 to 2.6% due to slowing growth in the EU, primarily Germany.

Headline CPI inflation was 2.2% y/y in October 2018, which will be the yearly average rate, down from 2.5% in 2017. Nevertheless, inflation is above the 2.0% target, and with nominal wage growth at 8.6% in 2Q 2018 and a relatively weak CZK, it is unlikely to moderate any time soon. We expect inflation to accelerate to 2.5% in 2019 driven by household consumption and an expansionary fiscal policy.

The Czech National Bank (CNB) signalled that its tightening cycle has ended after its November meeting when it hiked the repurchase rate by 25bps to 1.75%. However, we and the market expect further hikes as the CZK will not strengthen as much as the CNB expects to 24.4 against the EUR without further tightening. The repurchase rate will reach 2.50% by 3Q 2019.

The current account generated a surplus the first nine months of 2018 that was nearly identical in size to the surplus in the same period in 2017. We expect the surplus to

narrow in the coming 6–12 months, but the deterioration will likely be offset by an increase in portfolio and foreign direct investment flows in 2019. Despite political turmoil, government finances have been on an improving path, pushing down government debt to 32% of GDP.

Pro-Russian political views have been gaining ground in the Czech Republic, as it has in many European countries. Nevertheless, the Czech Republic will remain in the EU as both the current administration led by PM Andrej Babis and his ANO movement and public opinion are in favour of staying in the EU. Proposals by President Milos Zeman to hold a Czech exit referendum is unlikely to succeed. Elections need to be held in or before October 2021, but the minority government is unlikely to survive that long. In any case, given the healthy state of public and external finances, the market impact in the event of new elections will be minimal.

Ukraine According to preliminary estimates by the State Statistics Service real GDP of Ukraine rose by 2.8% in Q3 2018. Notwithstanding a slowdown from Q2 and Q1 when GDP growth was 3.8% and 3.1%, the economy has grown 11 quarters in a row. The situation is in line with the forecasts of the government and international institutions and GDP growth is expected to reach 3.4%. in 2018 We expect USD/UAH (now 27.75) to end 2018 at 28.25 and 2019 at 30.5, primarily because of relatively high inflation.

Household’s consumption and fixed investments were the key drivers of the economy in 1H2018. The weaker 3Q18 GDP result is due a slowdown in agriculture, which showed outstanding growth in 2Q18 due to shifted seasonality. Household’s consumption will remain the key growth engine in 2018 driven by higher real wages with improved consumer sentiment and substantially increased inflows of remittances thanks to labour migration (est. +24.7%).

Growing private remittances (est. USD 11.6 billion in 2018) should partially offset the negative impact of rising consumption and higher energy prices on the C/A deficit. Furthermore, the government is issuing bonds, obtaining another IMF tranche and aid from IFIs that will allow it to reach a balance and increase FX reserves to USD 19.2 billion at the year end.


The IMF and Ukraine have reached a staff-level agreement on a Stand-By Arrangement. The USD 3.9bn, 14-month loan program will replace the existing EFF program, which was launched in 2015 and enabled Ukraine to receive USD 8.5bn in lending out of USD 17.5bn offered. The new program will focus on continuing with fiscal consolidation and reducing inflation, as well as reforms to strengthen tax administration, the financial sector and the energy sector. The first tranche under the new program will become possible after the 2019 budget is approved with the required deficit target of 2.4%.

At the end of October Ukraine successfully placed 5-year Eurobonds at 9.0% and 10-years at 9.75% raising in total USD 2 billion. Ministry of Finance’s placement rate will be used as a benchmark for the placement of the 5-year bonds of Naftogaz.

Headline inflation gradually has decelerated to 9.5% y/y as of October and will be 10.2% at the year end. Consumer price inflation slowdown was driven partly by weaker growth in food prices amid more ample supply of domestic and imported foods and partly due to hikes in the key rate by the Central bank to 17% and then to 18%. Inflationary pressures are significant, while growth in administered (gas price hike 23.5% for households) and fuel prices accelerated.

Latin America

Brazil The BRL looks set to strengthen in the coming 1–3 months, lifted by a temporary rebound in global growth from the weak 2nd and 3rd quarters, a small increase in commodity prices and signals of fiscal consolidation and economic reforms from the new government. We expect USD/BRL (now 3.76) to move down to 3.60 at the end of December 2018, but to end 2019 higher at 4.25.

Signs of what kind of economic policy the newly elected president, Jair Bolsonaro, and his team will pursue are very encouraging. The proposed minister of the economy is Paulo Guedes, a Chicago-trained economist and an avowed fiscal hawk looking to reduce the role of the state in the economy.

In addition, the government is making a push for Congress to approve the pension-reform proposal submitted by the outgoing administration. Appointments to the BNDES and Petrobras suggest that private investments will be encouraged. The proposed new head of Banco Central do Brasil (BCB), Roberto Campos Neto, is a well-respected economist which, together with the government’s plan to award the BCB formal autonomy, will boost the credibility of the bank.

However, while the Bovespa stock index has risen by more than 17% since September (touching an all-time high on November 5) when it became clear that Bolsonaro would win, the FX market has not taken much notice. The BRL has traded largely on changes in global risk sentiment and commodity prices. So, what should we expect from now on?

First of all, the domestic economy will not provide much support. It continues to recover from the deep recession 2014–2016, but the recovery is slow. Real GDP expanded by 1.0% in 2017 and will grow at a similar pace this year, dragged down by a strike by truck drivers in May-June and weak external demand. PMI readings and business confidence indexes for Brazil have recovered lately, but due to the large fiscal consolidation that will be required to put public finances on a sustainable footing, growth will remain relatively slow at 2.5% in 2019. Productivity enhancing reforms promised by Bolsonaro will boost growth no earlier than late 2019 or 2020, if he succeeds in convincing Congress to pass the measures.

Inflation has accelerated from about 3.0% in the beginning of 2018 to 4.6% in October 2018. We expect inflation to average 3.8% in 2018 and stay close to the BCB’s central target of 4.25% in 2019. However, in order to anchor inflation and inflation expectations around the target (against the background of a pent-up demand to raise prices to compensate for previous losses), the BCB will have to tighten monetary policy starting in 2Q 2019. We expect the Selic (now 6.50%) to be 6.75% in 2Q and 7.25% at the end of 2019.

Mexico The MXN is undervalued based on the past performance of the Real Effective Exchange Rate (REER). However, we do not expect a significant rally to take place in the coming 3–6 months. The leftist president-elect, Andrés Manuel López Obrador (AMLO), will take office on December 1, 2018, but has already rattled investors by vowing to cancel a major airport project outside Mexico City and propose a cap on bank fees. While the long-term macroeconomic impact is uncertain, the cancellation will be costly for the government. It has also corroborated fears that economic policy will be unpredictable under AMLO and that he may roll back energy sector reforms. MXN will be very sensitive AMLO’s policy initiatives, which on balance look negative for the MXN. We expect USD/MXN (now 20.40) to reach 20.50 by the end of 2018 and 21.50 in 4Q 2019.

Real GDP growth averaged 2.2% in the first nine months of 2018 and looks set to reach 2.3% for the year as a whole. The replacement of NAFTA with the USMCA removes a major uncertainty from Mexico’s economic outlook. Granted


that the US Congress approves the agreement without major revisions, growth will be supported by healthy growth in the US next year. A headwind will come from the change in government in Mexico, a time when many public investment projects stall, leaving growth at 2.1% in 2019.

Inflation has moderate to 4.9% y/y as of October 2018, down from 6.0% in 2017. Yet, it remains above Banxico’s 3.0% (+/-1ppt) target, driven primarily by higher energy prices. Persistently high inflation and MXN weakness has prompted Banxico to hike its policy rate to 8.00%. Given the hawkish statement after Banxico’s latest rate hike in November and the risk of further MXN weakness we expect one more hike to 8.25% in December 2018 before the tightening cycle ends. Inflation will moderate to 3.5% in 2019, due to base effects, sluggish domestic demand growth, and a drop in world oil prices. Banxico’s hawkishness will be a key support for the MXN in the coming months as AMLO takes office.

The current account deficit will likely narrow in the coming months on lower oil prices, strong demand from the US, and weak domestic demand. Nevertheless, the support for the MXN will not be enough to fully offset investor worries surrounding AMLO.

Sub-Saharan Africa

South Africa The ZAR has been strengthening gradually since September 5, a trend that will continue through December, pushing down USD/ZAR (now 13.85) to 13.50 by year end 2018. Nevertheless, the ZAR will weaken over the next 3–6 months due to sluggish growth, high inflation, and low commodity prices. We expect USD/ZAR to end 2019 at 15.50.

Sluggish economic growth will be a headwind for South African markets next year. Real GDP growth is on track to reach only 0.6% in 2018 after experiencing a recession in Q1 and Q2. Monthly data point to a slight pickup in activity in 3Q, but business sentiment and PMI readings remain

depressed, suggesting that any rebound in growth in the coming months will be small. We expect growth to increase to 1.8% in 2019 partly driven by expansionary fiscal policy and partly by a recovery in the agriculture sector, which was hit by on adverse weather conditions this year.

Inflation rose to 5.1% in October (chiefly due to rising energy costs and VAT increases), above the 4.5% central target, but inside the 6.0% upper limit. Next year, inflation looks on track to average 5.5%, pushed up by higher electricity tariffs. The South African Reserve Bank (SARB) was on the verge of hiking its policy rate in September. With inflation set to rise toward the upper end of the target corridor, we expect the SARB to hike its policy rate to 7.50% by the end of 2019 (from the current 6.75%).

The current account deficit will narrow to around 2.0% of GDP in 4Q 2018 and 1Q 2019 from almost 4% in the first half of 2018. However, foreign direct investments into South Africa are insufficient to finance the deficit. The narrowing of the deficit will provide limited support to the ZAR if global growth slows and commodity prices remain depressed, as non-resident portfolio investments into the bond and equity markets will suffer.

South Africa suffers from twin deficits, i.e., both the current and the fiscal account. Newly appointed Finance Minister Tito Mboweni announced that the budget deficit will exceed initial estimates and instead widen to 4.0% in 2018/19 from 3.1% in the previous budget year.

Two risks related to politics may affect the ZAR next year. The first is the plan to redistribute land without compensation to owners. The government under President Cyril Ramaphosa is pushing for a change in the constitution in order to carry out the reform. However, a change in ownership rights is spooking investors. The legislative process will be lengthy and will weigh on market sentiment throughout 2019 and possibly into 2020. The second is the general election that will be held by August 4, 2019. The ANC looks likely to win the election, albeit with lower support than previously. The risk of populist policy proposals and fiscal slippage are significant.


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