As EM adjustment pressures policy rates, EM domestic demand is more at risk
* Pressure on policy rates, dom demand
Turkey’s large emergency rate hikes highlight the ability of asset markets to influence action. The adjustment focus appears to be moving from FX to policy rates, which have a more direct effect on domestic demand in EMs with a C/A deficit, and put domestic cyclicals and financials more at risk, in our view. We continue to prefer DM-facing exporters, and North Asia. MX and RU may face currency volatility because of portfolio flows, but we feel this may create an attractive entry point.
* Weak bond inflows, more rate pressure
We feel that the ongoing tapering process will reduce the appetite for EM assets, particularly bond flows, which have offset rising EM C/A deficits since 2009. US data suggest the appetite inflected around the May ‘taper tantrum’; the large exposure of EM bond funds to C/A deficit countries doesn’t help investor appetite.
* FX exposure remains high in places
Foreign ownership of local currency bonds and cross-border bank loans implies that significant FX exposure remains in certain EMs. We compare these exposures to FX reserves, and highlight the relative risks in SA, TK, MX, and ID.
* SA back to U/W, with TK, ID and BR
A move to higher rates should accelerate the C/A adjustment but will come by broadly impacting domestic demand, especially in countries like South Africa and Turkey, where domestic demand and financial sectors are large and have high valuations. We swap Thailand (to Underweight) and Malaysia (to Market weight).