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Will Brexit Break EMs Back? Governments and Markets

The next shoe to drop in Emerging Markets?

The immediate flight to risk assets has helped the dollar, as one would imagine given the composition of the dollar index:

A strong dollar is negative for Emerging Market assets and currencies in particular, with the next round of EM devaluations a strong possibility as the African currencies lead the way. This started last week with the Naira falling 40% and we could see further pain in the likes of Egypt and Angola, with the Rand one of the worst performers today, down 6%.

Mark cautions that the Yen may rally further, off-setting some of the dollar strength, but the reaction of the Eurozone (further referendums or state intervention) and where the pound stabilises should determine near-term performance.

While the moves today have been large, we can see that the Euro is still nowhere near its lows since the start of last year, so we have room to run.

The key for determining how badly EM will be impacted will be the second order impact in Asia as a resumption in the dollar bull market and increased political uncertainty puts further pressure upon China, where we maintain our view that the structural imbalances are likely to come to a head this year, leading to another wave of weakness in EM Asia as competitive devaluation renews. A slowing China versus stable expectations would also weigh further afield, with Australia a key concern in this environment as Mark and JP discussed in a recent report.

We should also note the recent change in sentiment toward India, where well-regarded central bank governor Raghuram Rajan has been pushed out on ostensibly political factors, a key risk factor we highlighted earlier this month given his statements against crony capitalism. While we doubt the fallout from this will be as bad as the last time a central bank governor took a principled stand, the ousting of Lamido Sanusi in Nigeria, incremental flows into India may be muted while investors await more clarity.

While some Emerging Markets, such as Russia, may seem to come out ahead in this game having already devalued significantly, their interaction with commodity prices in most cases remains key.

Russia (and China) do benefit from a more fractured Western bloc in line with their ambitions for a divide and conquer strategy. In particular, the absence of the more hawkish UK in future sanctions discussions on Russia is likely to tip the balance in favour of a resolution in line with the more dovish view growing in Germany in particular. The positive impact of this may be offset by weakening demand in Europe, but we should see Russia become even more assertive as a result.

Even absent China cracking, we remain negative on commodities and oil in particular through the summer as Canadian and potentially Nigerian crude comes back online and demand flattens out, with crude potentially hitting $35 once more. I remain very bullish on crude into the end of next year after a summer swoon, while JP remains in the new normal of a lower oil price camp.

Other Emerging Markets that benefit from lower commodity prices, such as Turkey, that have had weak currencies, are unfortunately moving in the precise wrong direction in terms of governance and state interference for positive performance of assets.

One curiousity is that some Emerging Markets, such as Brazil and Argentina, are actually moving in a less populist direction even as developed markets turn more populist. This is to try to rectify some of the excesses of the populist period and may yield dividends depending on the path they take.

The safest bet oddly in these markets may be Middle Eastern markets, which have only marginally rallied with oil prices, have stable dollar pegs for the next year at least and are starting to head in the right direction in shifting their governance regimes.

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