UBS: Emerging Markets Are Entering 'a New and Dangerous Phase' in 2016

Balance sheets are in disarray.

Will We See More Downside in Emerging Markets in 2016?

Just like Christmas music, the year-ahead previews from Wall Street seem to come a little earlier each year.

UBS's global strategy team recently released its 2016 Outlook, in which strategists detailed the macro developments—such as liftoff from the Fed, acceleration in European growth, moderation in China's expansion, and the persistence of disinflationary pressures—that are likely to shape market returns in the coming year.

The strategists are cautiously optimistic on the outlook for global equities and do not expect carnage in fixed income. If there's one asset class UBS is unreservedly bearish about, it's emerging markets.

The developing world is "entering a new and dangerous phase," according to strategist Yianos Kontopoulos.

"[U]p until recently, weak EM growth was largely seen as part of an adjustment narrative, where currency depreciation and soft domestic demand allowed EM economies to transition away from unsustainable external balances, [but] this narrative is now changing in one fundamental way," he wrote. "After several years of weak growth, EM macro balance sheets are eroding fast."

In previous years, UBS has observed a divide between flow and stock variables for emerging markets. While their aggregate ability to generate earnings was slipping, debt-servicing capabilities were not a cause of great consternation.

"However, balance sheets can't remain independent of income statements forever," Kontopoulos said. "Weak global trade and delayed reform implementation have caused enough erosion in EM's leverage, fiscal and external dynamics to now make balance sheets a concern in their own right."

UBS used a variety of economic and financial metrics to assess the strength of emerging market balance sheets. It has concluded that they are in their worst state in a decade.


"This is important because it is only since 2005 that EM debt has attracted serious investment," explained Kontopoulos. "The structural macro improvements that these EM debt investors enjoyed, and hoped would persist, has now all been reversed."

The rest of the global economy isn't poised to provide substantial support for emerging markets: China's leadership has telegraphed a slowing in the rate of growth for the world's second-largest economy, which previously served as the driving force behind the broad outperformance of EM assets, and advanced economies aren't strong enough to offer a noteworthy boost in demand.

Kontopoulos acknowledged that an improvement in the current accounts of many emerging market nations (including a battered Brazil) could serve as the source for economic and financial market stabilization. But the factors underlying and accompanying this development—weak export trends, import compression, and lower inflows—should not be considered wholly positive for the space, he contended.

As such, UBS believes that the recent relief rally emerging market assets have enjoyed—which, somewhat surprisingly, occurred amid an increase in the market-implied probability that the Federal Reserve will initiate a tightening cycle in December—is likely to dissipate.

The impetus for upcoming underperformance in emerging market currencies, equities, and credit will be wider spreads that increasingly reflect the deterioration in their balance sheets, the strategist said.

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