Fed hikes.What now?:Implications for EM equities The US economy seems stuck in first gear....

As anyone who visited dentists’ chair knows well, leaving surgery is aeuphoric experience of relief and perception that one is rejoining the rest ofhumanity. The reaction to the well-telegraphed Fed decision to raise rates by25bps falls into this category. Whilst bond and currency markets have notreacted much, less macro fundamental equity markets were euphoric that thewait was over and the Fed is likely to remain dovish and data-dependent, tosupport risk-taking. Interestingly, inflation break-even rates have actuallyretreated slightly, implying lack of confidence in ability to return to 2% inflation.

In our view, from the global perspective, the key take-away from today’sannouncement and associated “dots” is that through ‘16-17, the US economyis likely to remain stuck in first gear, with nominal growth rates remaining inthe ~3%-3.5% range. This confirms our view (and recent academic studies)that the GFC and associated overleveraging & overcapacity caused what islikely to be a permanent decline in potential and actual output. This impliesthat the US would be unable to inject much demand into the global economy,particularly given that it is now growing via lower multiplier activities.

...ability to continue to tighten dependent on US$

We maintain our view that as long as the Fed remains dovish and gradual andneither ECB nor BoJ embark on more aggressive expansion of their monetaryaccommodation and so long as leading indicators in Eurozone and Japan tilttowards mild recovery, DXY (US$) is likely to remain contained at ~95-100and might even depreciate slightly as perception of tail risks declines. In thatscenario, commodities complex should stabilize and currencies of commodityexporting nations should also stabilize and/or slightly appreciate. Theheadwinds buffeting EM equities could become less pronounced, supportingsome ST rotation into markets like Indonesia, Malaysia, Brazil, SA, etc.

However, over the longer term (6-12 months), we maintain that supply of US$would remain exceptionally tight (and indeed could further deteriorate asneither US CAD nor Fed policies would support an improvement). We alsomaintain that it is highly unlikely that either Eurozone or Japan would be ableto exit their respective liquidity traps, implying a need to further reassesspublic (including monetary) policies to depreciate currencies and alterinflationary outcomes. As Fed gradually tightens this should lead toappreciation of US$ (potentially significant), in turn prompting more robustdepreciation of Rmb; further erosion of commodities complex and heightened(rather than lowered) disinflationary pressures.

Continue to be positioned in a ‘safer’ end of EM universe

Over even longer term, EMs are facing a poor combination of lack of growthand trade, changing manufacturing landscape, tighter liquidity and higher costof capital. At the same time, global returns on human capital are likely tocontinue to drop and unfortunately it is human capital that is in excess supplyacross most EMs (turning demographic dividends into more familiar curses).

We do not currently see any signs of distress in EM universe (markets areneither significantly undervalued nor sold-off). We therefore prefer to remainin countries with lower degree of external vulnerabilities, with O/W tilts inIndia, China and to a lesser extent Korea and the Philippines.