While PIMCO’s cyclical outlook is cautious overall, our outlook for emerging markets ex China(EM) is more constructive. We expect further improvement in the EM macro picture as most emerging economies are at a different stage of the economic cycle than developed economies and they are still benefiting from relatively easy global policy conditions. Both of these should support a rebound in economic activity and continued disinflation.
Yet because valuations on EM debt are high after this year’s rally and market volatility is likely to increase in the months ahead, the days of relatively easy returns for investors in EM may be passing.
Growth in EM rising
EM growth has been stabilizing at lower post–financial crisis levels, with a smaller differential to developed market (DM) growth, for some time. In 2018 we expect EM growth1 to rise to 4.0%, which is slightly above consensus, led by consumption and recovering global trade. Recoveries in both Russia and Brazil will likely become more entrenched, while growth in Mexico and India should remain robust.
EM as a whole remains anchored to the fortunes of the global economy, and one of the main risks to our growth forecast is the potential for change in U.S. trade policy. Prior to the financial crisis in 2008, a larger U.S. current account deficit lifted EM growth to 6%–7%; after the crisis, the U.S. current account adjusted lower, and so has EM growth. From here, a more protectionist U.S. in the North American Free Trade Agreement (NAFTA) negotiations or toward China could possibly drive growth much lower than our baseline, toward the 2% level.
Disinflation: cyclical, not structural
Inflation is likely to decline across EM in 2018, with headline CPI (Consumer Price Indexes) expected to converge to around 4.2%. In Brazil and Russia, inflation should be well within their respective inflation targets, while in Mexico, where CPI has been higher than target, we expect to see inflation declining below 4%.
Our analysis suggests that the current disinflation across EM is mostly a cyclical decline led by food and energy prices, rather than a more structural phenomenon, as core inflation has yet to show a sustained decline. As a result, the current difference in real interest rates between EM and DM for the most part does not look out of line with the expected improvement in EM fundamentals.