Politics will largely determine whether emerging market growth – and asset prices – recover in 2016

The international financial community expects 2016 to be a recovery year for emerging markets. After five consecutive years of sequential declines in economic growth, International Monetary Fund and consensus forecasts now look for a modest rebound, to roughly 4.5% from 4% in 2015. The improved outlook is expected to be anchored by stability in emerging Asia, and sharper recoveries in Latin America, Eurasia and the Middle East and North Africa. Emerging markets portfolio managers increasingly express optimism that there is value to be found in the EM investment universe.

Finding value in emerging markets in 2016 will require adept country allocation and risk management skills. In several key markets, unstable domestic politics — and evolving geopolitical uncertainties — now pose additional risks to growth and asset prices. This threatens the broader emerging markets growth recovery, and also casts doubts on the continued utility of emerging markets as a coherent concept and distinct asset class. Indeed, further differentiation in economic performance and asset price performance within the emerging markets world — and even within major EM regions — will remain a key investment theme in 2016.

Cyclical divergence between the U.S. and the rest of the world suggests emerging markets currency weakness will persist well into 2016. This creates policy challenges for many emerging markets, and perhaps especially for oil and other resource exporters, which might be forced to tighten domestic financial conditions at a time when the economic cycle would seem to call for easing. Less obviously, weak emerging markets currencies — especially if China cuts rates further to support growth — increasingly might generate negative spillovers from emerging markets into the broader global financial system.

In most of the major emerging markets, political stability in the next several months will largely determine whether growth — and asset prices — recover in 2016:

• Brazil's ever-deepening Lavo Jato corruption scandal — which has broadened into a systemic political and economic crisis — will only intensify further in the first half of 2016. Market hopes that the start of impeachment proceedings against President Dilma Rousseff in December will soon bring the scandal to an end are misplaced: Whether Ms. Rousseff survives the impeachment vote — and she likely will survive — domestic politics will create market shocks throughout the year. Economic reform will remain out of reach in 2016, and the government's attempts to cut spending and raise revenue will continue to face opposition. On top of this, Brazil has more dollar-denominated corporate debt than most emerging markets peers, making the financial system especially vulnerable to further dollar strength. High levels of pass-through from currency weakness to inflation complicate Brazil's prospects even more, as the very high spread between domestic interest rates and nominal GDP growth undermines Brazil's debt dynamics.


• In Turkey, the AKP's victory in legislative elections in November raised hopes that the resulting strong, stable majority government would have the political capital to pursue structural economic reform. Markets cheered the outcome, but improved government stability is unlikely to translate into better policies. President Recep Erdogan now dominates the AKP and seeks to create an executive presidency through constitutional reform. Economic policy will remain populist as he pursues those goals; the independence of the central bank, judiciary and other institutions will remain under pressure. Moreover, while military escalation is unlikely, the recent conflict with Russian President Vladimir Putin over the downing of a Russian jet in Turkish airspace poses some risks to bilateral trade and investment — and given the unpredictability of Messrs. Erdogan and Putin, risks of a broader escalation are real even if the probability is low.


• Russia is clearly headed toward a better year compared to 2015; the combination of low oil prices and Western sanctions is likely to result in an economic contraction of nearly 4%. Oil prices are unlikely to bring much relief to the Russian economy, but the increasing overlap in European Union and Russian interests over Syria likely will result in partial sanctions relief in the first half of 2016. While the economy may well remain in recession, weakening sanctions and Mr. Putin's potentially more constructive role in Syria justifies lower political risk premiums for Russian assets. To be sure, Russia's outlook remains negative: oil prices are low, reform and economic diversification appear unlikely, investment is lagging, and fiscal pressures on the government will continue to grow. Despite this, the very immediate future looks somewhat brighter for Russia than it does for many key emerging markets.


• Even in India, which has been a relative bright spot within the emerging markets since the election triumph of Prime Minister Narendra Modi and his Bharatiya Janata Party in May 2014, politics presents the primary risk to India realizing its potential as a high-growth market. India remains a star within the emerging markets world: It is the only major country pursuing productivity-enhancing economic reform that could credibly move trend growth to above 7.5% for the next several years. But despite this positive outlook, domestic politics increasingly is becoming a risk to growth and to asset prices, which are less discounted than most of the emerging markets. The opposition Congress Party continues to block the reform agenda in the upper house, most recently blocking passage of the goods and services tax reform, which now is delayed until the February-May budget session, at the earliest.

Although growth is slowing, China is one of the few major emerging markets where we are relatively less concerned about domestic political risks in 2016. Growth will continue to in 2016, to just more than 6%, but fiscal and monetary policy support suggests that hard-landing risks continue to be low. Moreover, slower growth has been associated with rebalancing, with economic growth increasingly driven less by excessive fixed-asset investment and more by consumption and services. All signs suggest the Xi Jinping administration remains committed to structural economic reform and will continue on the progress made in 2015.

China's domestic risks are overstated, but the country does pose larger challenges to the broader emerging markets universe — precisely because it enjoys more degrees of freedom than many other emerging markets. With the bulk of its debt runup since the 2009 denominated in renminbi, and an immense tradable sector, China has wide latitude to ease monetary conditions to confront sharply slowing growth. Its stock of reserves can be used to cover dollar-based liability mismatches in the corporate sector, and as this short-covering process is largely completed, risk-reward calculations can swing in favor allowing monetary easing to result in currency weakness. But while the size of China's reserves and trade surpluses give the country the ability to contemplate such an adjustment path, the impact of such policies on China's emerging markets competitors and raw material suppliers — particularly those indebted in dollars, or those with high inflation pass-throughs from exchange rate-weakness — will be much less benign.

Against this backdrop, broader emerging markets currency weakness will persist in 2016. This of course hurts dollar returns for dollar-based emerging markets investors, but poses several additional risks for global financial markets.

A stronger dollar would complicate the Fed's plans to normalize U.S. interest rates, exacerbating financial imbalances and the political debate over Fed policy independence. It may also sharpen the policy debate among global policymakers on the costs and benefits of financial globalization, challenging long-prevailing orthodoxy on the desirability of open capital accounts and floating exchange rates. In 2016, emerging markets currencies may increasingly become the developed world's problem.

Alexander Kazan is director of emerging markets strategy at Eurasia Group in New York.