Economic Outlook

Expect Further Divergence in Emerging Market Economies

Differences across EM in initial conditions, commodity reliance and sensitivity to U.S. Federal Reserve and dollar moves suggest economic outcomes are likely to diverge further.

Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy andfinancial markets. In the following interview, portfolio managers Michael Gomez and Lupin Rahman discuss PIMCO’s cyclical outlook for the emerging markets(EM).

Q: What is PIMCO’s outlook for growth and inflation in EM?
Lupin Rahman:Differences across EM countries in initial conditions, commodity reliance and sensitivity to U.S. Federal Reserve and dollar moves suggest we are likely tosee further divergence in economic outcomes over the next few quarters. Our baseline for the BRIM (Brazil, Russia, India, Mexico) economies as a whole isgrowth of 1.5%–2.5% year-over-year through the first quarter of 2016, with output gaps in the negative territory for most countries, particularly Braziland Russia. BRIM inflation is forecast to print around 6.0%–7.5% year-over-year with risks to the upside. Overall, we expect to see greater dispersionacross countries, with the commodity-exporting bloc likely to face stagflationary pressures as currency weakness keeps inflation high and sticky, even asAsian and Eastern European importers experience disinflation due to lower energy prices.

Q: How will U.S. policy normalization and dollar strength affect EM?
Mike Gomez:Historically, Fed tightening cycles have been associated with volatility in EM, and in light of EM’s sharply negative reaction to the 2013 “taper tantrum,”investors have naturally questioned how resilient the asset class will be in the face of an eventual Fed liftoff. Our baseline is that EM as a whole islikely to be able to weather a gradual and predictable Fed exit, but that there may be volatility and accidents along the way.

Underpinning this view is the reality that most emerging markets are entering this cycle with higher foreign exchange (FX) reserve buffers, lower externalindebtedness and more flexible exchange rate regimes, all of which leave them better positioned to withstand higher “risk-free rates” and a potentiallyextended period of U.S. dollar strength. Policy frameworks are also generally stronger, allowing several central banks to deploy countercyclical rate cutsdespite FX weakness and prospective Fed hikes. This is a marked departure from past experience.

That said, the recent period of plentiful global liquidity has produced pockets of froth. For example, since 2008 we have seen increased leverage in Chinaand, more generally, higher external leverage on EM corporate balance sheets. These are areas to keep an eye on and ones where we are focusing ourbottom-up analysis to help us better distinguish where vulnerabilities might exist. We also expect differences across regions, particularly as the EuropeanCentral Bank and Bank of Japan QE will likely be more supportive of emerging Europe and Asia, leaving Latin American commodity exporters more vulnerable.

Q: Mexico’s economy has historically been highly correlated with the U.S. How does PIMCO expect Mexico to navigate the Fed liftoff from zero?
Rahman:Mexico has navigated the post-crisis period relatively well and is progressing steadily on its planned structural reforms. Recent economic data point to adovish central bank bias given weak activity indicators, decreasing inflation and the ongoing drag from steady fiscal consolidation. These domesticfactors, together with the weaker peso and financial stability considerations, are likely to be driving factors for the Bank of Mexico’s (Banxico) ratedecisions. Our baseline, in line with recent comments from the central bank, is for any policy shift from Banxico to be well-telegraphed and in lock-stepwith the Fed. Nevertheless, in the event of an adverse market reaction, Mexico has strong policy buffers including the potential to increase FXinterventions, the availability of International Monetary Fund/Fed lines and the potential for local debt buybacks and other policy levers.

Q: Have emerging markets adjusted to lower commodity prices?
Rahman:Our bottom-up analysis indicates that, in addition to allowing their currencies to weaken to absorb some of the initial shock, many exporters have alreadystarted to consolidate their fiscal balances using more conservative commodity price assumptions for their 2015 budgets. However, some countries arealready behind the curve, both in terms of treating lower prices as a more permanent shock and being unwilling to adjust rigid policies on fiscalexpenditures and exchange rate regimes.

As for commodity importers, many appear to have adjusted rather rapidly to lower prices, with some proactively using the declines to alleviate the fiscaldrag of subsidized domestic energy consumption. These economies are already benefitting from lower current account deficits and improved fiscal balancesdue to the savings from lower oil prices and, as a result, they are seeing greater underlying support for their currencies.

Over the next few quarters, we expect further adjustments from both importers and exporters. Some will take advantage of the opportunity to make difficultstructural adjustments, while others will take a more myopic view and look to smooth the shock as a short-term phenomenon.

Q: What is PIMCO’s general outlook for Russia? Are there any areas for optimism?
Gomez:Russia is likely to face continued headwinds given the drop in oil prices as well as constraints due to geopolitical tensions, which are showing limitedsigns of near-term resolution. We expect the country to undergo a deep recession and inflation running in the mid-teens. Nevertheless, the combination of acurrent account surplus and drawdowns in the existing stock of FX assets should be more than sufficient for Russia to cover its upcoming externalobligations. This baseline is contingent upon a somewhat orderly financial environment in Russia and assumes a continuation of the status quo in easternUkraine, albeit with occasional flare-ups of violence. We recognize there are tail risks to this, both good and bad, but the pricing of Russian assetssuggests the market is more skewed toward the left tail of the distribution of outcomes. Thus, we see opportunity, particularly among issuers with strongfree-cash-flow generation.

Q: Brazil appears to be progressing on the reform front, albeit with many challenges ahead. Can the new financial team’s focus on reforms bring a return to growth in 2016?
Rahman:We expect 2015 to be another difficult year for Brazil, with macroeconomic risks compounded by several negative shocks including potential energyrationing, the Petrobras scandal and the adjustment to lower commodities prices. Our baseline is for a contraction of 0.5%–1%, with meaningful downsiderisks given the potential for lower investment from the energy sector and lower external demand given the drop in commodities. Meanwhile, inflation willremain high and above the 6.5% upper bound of the inflation target range as the upward adjustment in regulated prices continues and recent currencyweakness passes through to prices. This challenging macro backdrop together with a more difficult political landscape make the planned fiscal adjustmenteven more critical to foster confidence in the government and improve the business environment in 2016 and beyond.

We expect to see Finance Minister Joaquim Levy deliver a fiscal adjustment close to his initial announcement using a combination of cyclical measures suchas discretionary spending cuts as well as some progress on expenditure and tax reforms. Fiscal consolidation, along with improved central bank credibilityand movement in the exchange rate toward a more flexible and fair level for the currency, should go a long way toward addressing the recent buildup ofimbalances and eventually underpin strong growth in the medium term.

Q: What are the investment implications of PIMCO’s cyclical outlook for EM?
Gomez:Taken together, the backdrop suggests a high degree of differentiation is required ahead in the EM asset class, and PIMCO is focusing on selectopportunities across countries, credits and markets. While currencies remain the most vulnerable given their role as the macro release valve, we see valuein a scaled basket of EM long positions funded with non-U.S. dollar core currencies to remove the dollar risk, particularly in EM currencies that havealready adjusted significantly. We remain cautious on overall duration given valuations, and instead prefer to express EM longs versus shorts in core ratesmarkets that appear fully priced. Finally, we remain focused on strong-balance-sheet credits in the sovereign and corporate space, which we view asrelatively more anchored in the current global backdrop of lower commodities prices and desynchronized global central bank actions.

The Author

Lupin Rahman

Head of EM Sovereign Credit

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