Emerging Market growth remains sluggish

EM growth remains sluggish, and is still running 50-60bp below potential. China's devaluation of the CNY added uncertainty to a picture already complicated by impending Fed hikes.

Weaker EM currencies will likely pressure commodity demand further, and coupled with added supply, will keep prices depressed. EM growth forecasts remain below the consensus.

Next year's recovery is partially a cyclical rebound after below-trend growth in 2015, but is very much dependent on China slowing gradually, the G-3 economies recovering in line with the forecasts, and commodity price weakness being contained. 

The selloff in EM currencies has created concerns that most central banks will have less room to cut policy rates even if growth remains sluggish and inflation low. In fact, pressures to tighten monetary policy have started to build. If the Fed starts its tightening cycle in September, the market reasons, EM central banks will not be able to cut, even if they need to. 

Markets are already pricing in September hikes by the central banks of Colombia, Mexico, and South Africa. Additionally, the market has moved forward the priced-in start of the tightening cycle in Chile and Malaysia to late 2015 or early 2016. In Turkey, expectations are building for another sharp cycle of hikes by the CBT. 

"We tend to disagree with the market view. Recent actions by the PBoC show EM central banks can and will move independently of the Fed. In our view, sluggish EM growth will limit the need for EM central banks to follow the Fed right after it begins to hike", says BofA Merrill Lynch.

In Mexico and South Africa, no tightening is expected until early 2016. In Colombia, BanRep is expected to remain on hold for now, but to cut rates toward the end of the year as the activity slowdown becomes more entrenched and evident for the board.