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Global Debt: Quarterly Macro Update
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Recent Developments in Latin America
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Financial contagion—with Argentina and Turkey at the epicenter of the emerging market (EM) sell-off—led to significant sell-offs in currencies and interest rates in India, South Africa, and Indonesia. For emerging markets to do well, we believe that global growth—particularly non-U.S. growth—needs to be stable or accelerating, and financial conditions in the United States, and more broadly in EM countries, must be stable or improving.

EM growth did slow down. That development, along with tightening financial conditions in the United States, were the primary causes of the negative performance for EM. Given that European growth showed signs of stability in the third quarter of 2018, European risk assets were largely stable.

Trade tensions continued to escalate in Q3, with tariffs being imposed on a large swath of imports from China. On the positive side, a trade agreement that will replace NAFTA was negotiated with Mexico and Canada.

With the current weakness in emerging markets, we think global growth has peaked. Over the next nine months, we expect developed market (DM) growth will slow down, as EM growth bottoms out at some point in the second quarter of 2019. While we believe U.S. growth will slow down from its current rapid pace, we expect U.S. growth will remain well above potential or trend for the next two to three quarters, with the risks that inflation could surprise modestly to the upside.

We also believe that European growth will remain in the Goldilocks range of 1.5% to 2%. In Europe, we are seeing signs that wages are starting to pick up and capacity constraints are beginning to be an issue for many companies. As investments have lagged for almost a decade, productive capacity has not kept pace and current utilization rates are close to record highs.

In emerging markets, we expect that some countries’ improving domestic fundamentals and possible fiscal stimulus in China could offset the effect of tariffs. If those positive developments continue to unfold, we think that by the second quarter of 2019 they will help abate the current slowdown in EM countries.

We are keeping a close eye on global trade. With the headwinds on trade from tariffs, we are closely monitoring the extent of the trade slowdown to determine who may be the winners and losers.

Developed Market Growth

The third quarter of 2018 proved to be a continuation of second-quarter themes. The U.S. Federal Reserve (Fed) delivered another interest rate hike, eliminated its description of monetary policy as “accommodative,” and increased the long-run dot plot. After the European Central Bank (ECB) announced the end of its quantitative easing (QE) last quarter, its decision makers’ rhetoric turned mildly hawkish. ECB President Mario Draghi expressed confidence in the Eurozone outlook and highlighted a “relatively vigorous pick-up” in underlying inflation. Italy continued to create negative headlines as the government drafted a budget plan that is not, in its current form, in line with Eurozone fiscal rules.

Global trade tensions remain escalated, with the U.S. imposing tariffs on $200 billion of Chinese imports and threatening additional tariffs will be levied if negotiations stall. On a positive note, there was a successful negotiation to replace the North American Free Trade Agreement (NAFTA) with the new United States-Mexico-Canada Agreement.

Eurozone data that was previously weak seems to have stabilized in the second half of the year. The underlying forces of growth in the Eurozone—such as job creation and income growth, a revival of bank lending, and high levels of confidence—are intact and growth should remain in the 1.5%–2% range. Japan’s growth rebounded in the second quarter in response to strong investment expenditures. Growth expectations remain upbeat in several other developed countries, including Canada, Australia, and Sweden.

Impact of Global Headwinds on Asia

Global headwinds are catching up with Asian growth. In Q2, as we expected, Chinese growth started slowing down, as a result of earlier tight monetary policies that were enacted to reduce financial leverage in the economy. With trade disputes taking a turn for the worse, we expect this slowdown will continue and some of the pain will be shared with the rest of manufacturing Asia through lower exports, exchange rates, and lower profit margins.

Clearly, the impact may take some time to show up in real economy, with the timing depending on the reach and impact of tariffs on the global supply chain. A number of countries in the chain stand to lose from lower trade, but some are likely to gain from the potential relocation of production and from their increased exports to Chinese domestic consumers.

We think China will mitigate most of the growth impact on its domestic economy by a combination of looser fiscal policy and more adjustments in the exchange rate. However, the indirect impact on investor sentiment and investments is likely to induce a further slowdown in Asia broadly, even though a still resilient capital expenditure demand from developed markets will provide some support to the region.

Despite these headwinds, we still see Asia EM growth stabilizing by the second half of 2019 on the back of policy support from China, at a time when DM growth is expected to slow down from above trend. There are other headwinds to the region besides trade most notably higher oil prices, especially for current account deficit countries such as India and Indonesia. Hence, we remain cautious and consider risks tilted to the downside, especially if trade tensions escalate further.

Latin America’s Outlook

Our new outlook for Latin America, with downward growth revisions, is driven by the larger economies where domestic and external headwinds are greater, especially in the case of Argentina. The other economies in the region continue to follow cyclical momentum, moving toward potential growth. We now see the region growing 1.5% this year, down from 1.7% in 2017, and also below the 2.4% potential. Barring bad political outcomes, the lower current account deficits and historically low inflation support demand. These are external and domestic factors that should help Latin economies in this period of divergent global growth and unstable markets.

Argentina was one of the “Fragile Two” economies, along with Turkey, that suffered unsustainable market stress. In the absence of tighter fiscal and monetary policies, foreign lending stopped. Argentina’s currency suffered a mini-crisis, as markets made the adjustment. In turn, the response to the peso plunge was a revised International Monetary Fund (IMF) program. A more demanding program will inflict strong headwinds in front of economic activity, bringing the economy deeper into recession and calling into question the resilience of its social fabric and its policy environment. We see both the IMF and the administration of President Mauricio Macri as fully committed to the success of the program.

Portfolio Implications

From an asset valuation perspective, these conditions have driven EM assets to historically inexpensive levels relative to DM assets. Emerging market local bonds offer real yields that are at or close to 15-year highs when compared with developed market real yields. Among those countries where the central banks have raised rates, we see value in short-term interest rates. In the countries where the central banks have not fully tightened, we see value in long-term bonds, particularly if the yield curves are very steep. Similarly, emerging market currency levels are back to levels last seen in 2015, near the U.S.-dollar high.

We maintain our view that the U.S. dollar will decline over the medium term. The U.S. dollar’s decline that started towards the ends of 2015 was interrupted by the large fiscal stimulus that impacted the U.S. economy this year. As the effects of this stimulus fade we expect the dollar to resume its downtrend for the next three to five years.