Emerging Markets: What has Changed

(from my colleagues Dr. Win Thin and Ilan Solot)

1) Moody’s downgraded its outlook on Brazil from stable to negative

2) Polls show a decline in Marina’s advantage over Dilma

3) Oil, iron ore, platinum, corn, wheat, soy, and rice prices are all making new lows for the cycle

4) The departure of Tusk from Polish politics leaves the PO party fractured

5) The US and the EU will reportedly announce a new round of sanctions on Russia

6) Argentina's lower house passed a bill allowing the government to pay its international bonds locally

Over the last week, Argentina (+2.4%), Czech Republic (+1.3%), and Turkey (-0.1%) have outperformed in the EM equity space as measured by MSCI, while Brazil (-5.7%), Colombia (-4.0%), and China (-2.3%) have underperformed. To put this in better context, MSCI EM fell -2.7% over the past week while MSCI DM fell -0.9%.

In the EM local currency bond space, India (10-year yield -2 bp), Czech Republic (-2 bp), and Korea (-2 bp) have outperformed over the last week, while Hungary (10-year yield +28 bp), Russia (+27 bp), and Brazil (+25 bp have underperformed. To put this in better context, the 10-year UST yield was up 7 bp over the past week.

In the EM FX space, CLP (+0.5% vs. USD), CNY (+0.1%), and PEN (flat) have outperformed over the last week, while COP (-2.3% vs. USD), ZAR (-2.1%), and BRL (-2.1%) have underperformed.

1) Moody’s downgraded its outlook on Brazil from stable to negative. Moody's kept its Baa2 rating, which is the same as Fitch's BBB. S&P is the leader, cutting Brazil to BBB- back in March 2014. Our model has it at BBB-, so a Moody's downgrade is very likely. While not a big surprise, it just adds to the gloom.

2) Separately, polls show a decline in Marina’s advantage over Dilma. However, Marina (47%) would still beat Dilma (43%) in the second round. Still, the narrowing of the difference was enough to curb much of the market’s enthusiasm for the Bovespa.

3) Oil, iron ore, platinum, corn, wheat, soy, and rice prices are all making new lows for the cycle. This has wide-reaching consequences for EM commodity producers and consumers. We would say that much of Latin America and Africa will be worse off, while much of Eastern Europe and Asia will be better off. Obviously, Russia is the main loser in Eastern Europe from falling commodity prices. On the flip side, sharply lower commodity prices will put downward pressure on global inflation. This should lead to less need for EM central banks to tighten.

4) The departure of Tusk from Polish politics leaves the PO party fractured. This could mean a period of political instability in what has been an otherwise very stable 7-year long leadership. A rival of Tusk, Grzegorz Schetyana, is making a bid to become the new party head. This will put him in direct confrontation with Ewa Kopacz, who Tusk favors. The new cabinet should be sworn in next week. We doubt this will have much market impact, unless the division proves deep enough to jeopardize the unity of the PO.

5) The US and the EU will reportedly announce a new round of sanctions on Russia. Press reports suggest that the new measures will come into effect this week, and they would be much stronger than expected. Russian oil exploration deals with Exxon and Shell could be put on hold, for instance. These include projects in the Arctic as well as deep sea and shale oil development. As noted elsewhere, plunging commodity prices will hurt Russia disproportionately. Lower potential supply from Russia will simply make matters worse for the nation.

6) Argentina's lower house passed a bill allowing the government to pay its international bonds locally. The bill would also allow global bondholders to swap into new bonds issued under domestic law. Both houses have passed the bill, allowing President Fernandez to sign it into effect. Due to all the legal and logistical hurdles, we do not think many bondholders will want to give up the protection of US law and be put under the potential vagaries of Argentine law. Markets continue to see trouble ahead, with the Blue Chip peso exchange rate currently trading nearly 60% weaker than the official rate (13.295 vs. 8.41). This is the largest gap on record.