There are two main channels by which Brexit could impact emerging markets (EM): financial markets and economic activity.

What impact should we expect from financial markets?

So far, fears of financial market seizure seem to have been contained. Global safe-haven assets certainly benefitted in the aftermath of the vote (the US 10-year fell below 1.5%, German 10-year pushed further into negative territory and the Yen briefly touched 100:USD), given the expected decline in global economic growth and hopes of additional monetary policy stimulus from developed market central banks. Indeed, Fed funds futures are now pricing less than a 50% chance of a hike before 2018! This in turn has helped bolster risk assets, with major equity market indices in Europe, Japan and the US close to pre-Brexit levels. Meanwhile, EM assets have been relatively firm, as financial markets currently see the net effect of lower developed market growth versus more accommodative monetary policy as benefitting rather than harming EM, given their limited UK exposure.

Figure 1: Brexit impact

Brexit shockwaves

Source: Nikko Asset Management

What will be the impact on real activity in Emerging Markets?

Currently, the picture is far from clear, as much depends on: 1) the impact on growth in the UK, Europe and the globe during the upcoming period of uncertainty; 2) the nature of the trade negotiations that the UK enters into, both with the EU and other trading partners; 3) the risk of further political contagion and 4) the policy response from both governments and financial institutions. What is clear is that direct trade links from the UK to EM are, in aggregate, low; however, the magnitude varies considerably by region, with CEEMEA most exposed relative to LatAm and Asia.

Figure 2: Export exposure of EM to the EU and UK

Export exposure of EM to the EU and UK

Source: JP Morgan

Brexit Impact: The Outlook for CEE4 (Poland, Hungary, Romania, Czech Republic)

As Figure 2 shows, within EM, CEE4 countries have the highest trade links with the UK and EU. Within the region, while Poland has the highest trade with the UK as a proportion of GDP, it is still relatively low, at less than 7%. Hungary and Czech Republic, meanwhile, have generally greater ties to the rest of the EU, as well as generally more open economies. It is therefore the second order impact of lower EU growth that would likely have a bigger impact on CEE4 growth. Aggregate CEE4 GDP could fall by about 0.5% in 2016 and 2017 combined, with Hungary and Czech Republic likely to suffer relatively more (with a 0.5% to 0.7% drag) than Poland (0.4% to 0.5%) and Romania (0.3%).

The principal driver of the slowdown is expected to be uncertainty weighing on trade and investment, while remittance payments should only be marginally impacted. However, the longer term impact is far less certain, and will be dictated by the duration of the uncertainty period, post-EU UK trade deals and, crucially, the EU funding budget (post 2020). Since joining the EU, CEE4 economies have benefitted enormously from increased trade and EU structural funds (Figure 3), to which the UK was a top-three contributor (the latter being a key reason why Poland avoided recession during the GFC), so any decline in funding would be a material, longer term drag on growth for CEE4 economies.

Monetary Policy Response

Despite already historically low interest rates, most central banks in CEE4 have some space to lower rates further.

This is particularly true for Poland, where the key policy rate stands at 1.5%, while headline inflation has barely hovered above -1% in the past few months.

Czech Republic is likely to postpone the exit from the forex floor regime, and negative interest rates, which have already been in discussion for some time, could appear as a policy tool.

The Hungarian central bank's key policy rate is at a mere 0.9%, but the potential for a growth slowdown could see the authorities lower the rate further in measured steps. Other measures such as “Funding for Lending Schemes” could also be extended further, acting as monetary policy stimuli.

Romania's artificially low CPI rate (resulting from successive VAT cuts last year) is likely to rebound, yet with a key rate at 1.75% the central bank will likely abandon the prospect of hiking for the foreseeable future and could even cut further if the outlook deteriorates.

Fiscal Policy Response

The countercyclical policy response is unlikely to be uniform across CEE4, due to much different policy stance in those countries. Both Poland and Romania are unlikely to be in a position to deploy much stimulus via tax breaks or extra spending, as both countries' fiscal deficits are on the verge of triggering excessive fiscal deficit procedures. In Hungary and Czech Republic, the authorities appear to be in a better position to employ some measures of countercyclical policy response.

Politics

Politics, while highly unpredictable, also have the potential to be a highly disruptive factor for the region.

The result of the UK referendum was a massive encouragement to separatists and the nationalist movements in France, Italy and Spain, and is only the beginning of more political uncertainty in Europe during the months ahead.

For example, Italy is holding a referendum on constitutional reform in October. The reforms are sensible, but a referendum could be viewed by Italians as a mid-term anti-government protest. Currently, the polls are showing only a small lead for approval, but if Renzi loses, he promised to resign, so the country would be again politically unstable and early elections would take place in 2017. This would almost certainly mean a strong result for the Eurosceptic Five Star Movement, as we saw in the latest mayoral elections.

The impact would be mainly felt in Italy, where growth is already struggling and the banking system is very weak, but would also ripple through CEE4, where financial linkages with Italy are more pronounced than with the UK.

In Hungary, Prime Minister Viktor Orbán, emboldened by the Brexit vote, has announced an October referendum on quotas set by the EU concerning refugees (and the fine for each migrant they refuse to take) and has also managed to rally Slovakia to his cause in launching a legal challenge. This will prove yet another test for EU credibility surrounding its immigration policy.

In sum, although Brexit could cause further political turbulence, undermining the future of the EU project itself, we still see the risks of a “Hexit”, “Pexit”, “Rexit” or “Czexit” as low, given their reliance on funding. Non-Eurozone EU countries will also feel that they have lost a powerful ally against closer monetary union, which could drive a political wedge between those countries inside and outside of the single currency.

Figure 3: EU Funding allocation 2014-2020

EU Funding allocation 2014-2020

Source: JP Morgan

Brexit Impact: The Outlook for Turkey

The perceived panacea of future EU membership, while always remote, is now looking even more elusive for Turkey, given growing political divisions and a likely wait-and-see period for EU member expansion.

Turkey's trade with the UK is the highest in EM, while the EU as a whole is Turkey's largest export market, both of which are expected to decline post-Brexit. Tourism is likely to take a further hit, after already reeling from a Russian boycott and concerns over terrorist attacks. Unlike CEE4, however, Turkey is more sensitive to US dollar financing, which, with the Fed likely to delay rate hikes until later this year at the earliest, should mitigate some of the impact.

Monetary Policy Response

The central bank of Turkey is in the process of monetary policy simplification, and for as long as inflation continues to ease, further cuts to the upper bound of the interest rates corridor are likely. A tolerance for slightly weaker currency has recently grown, with TRY being one of the better performing EM currencies during the most recent bout of forex volatility. Further cuts are possible in the light of Brexit related downside risks to growth, as long as inflation remains in check.

Fiscal Policy Response

The country is currently much better positioned to ease fiscal policy than in its recent past, thanks in the most part to lower commodity prices. The current account deficit is expected to come in a notch lower than 2%, which is comparable with other countries in the region.

Politics

Turkey is likely to be one of the losers of the UK fall-out with the EU. In the past, the UK was one of the strongest supporters of Turkey's membership, but the Leave campaign spawned fairly severe anti-Turk rhetoric, which could inspire similar tendencies among right wing/nationalist factions in other EU countries.

The recent improvement in ties with Russia and Israel could be seen as Turkey's attempt to secure new trade destinations, should exports with the EU falter on the back of weaker EU economic activity.

Brexit Impact: The Outlook for Russia

Russia should be relatively immune, when compared to CEE, as direct UK trade is minimal, but EU trade is relatively high, particularly with the former Eastern bloc.

Russia could be impacted if global growth falters, yet we see supply side factors likely to keep oil prices supported, thus helping to insulate Russia somewhat. Looser US dollar monetary policy should also support the country as it continues its external deleveraging.

Monetary Policy Response

An improving inflation outlook is likely to afford the ongoing easing of monetary conditions via the interest rate channel, should growth risks increase. Further declines in structural liquidity deficits on the back of fiscal deficits and running down reserve assets are also set to exert downward pressure on market interest rates.

Fiscal Policy Response

The fiscal stance is highly correlated with the outlook for commodities, particularly oil. At this stage, there is little room for a countercyclical stimulus.

Politics

Following the Brexit vote, although the EU is unlikely to backtrack on the six month extension to Russian sanctions passed on 1st July, consensus to extend further is likely to weaken, as Russia-friendly nations (such as Italy, Greece and Hungary) push for further dialogue against the current EU unanimity. Russia could also seize the opportunity of a likely lull in EU influence across Eastern and South-eastern Europe to increase its economic and political leverage in the region.

Brexit Impact: The Outlook for South Africa

With relatively limited trade exposure, the key issue for South Africa is the potential for contagion via global financial markets. BoP financing could also deteriorate, given the country's large reliance on the FDI from the UK. Nevertheless, we expect sentiment to be supported by monetary policy responses, particularly in the US.

Monetary Policy Response

The resurgence of inflation to, or above, 7% will likely be met with policy tightening if food prices reaccelerate. Therefore, at this stage there is no room for countercyclical policy stimulus, despite the already poor growth outlook. The central bank's single goal of maintaining price stability cannot be put to question at this stage, as institutional strength is one of the very few positives in SA.

Fiscal Policy Response

Weak growth momentum, coupled with a poor outlook and an already fairly sizable fiscal deficit will prevent the Ministry of Finance from relaxing its policy stance, as further deterioration is likely to push S&P to lower the country's credit rating to non-investment grade.

Politics

Brexit is unlikely to have a material impact given the already dire state of domestic politics.

Conclusion

In our base case scenario, we see a Brexit-related CEE4 economic slowdown in the near term likely to be met with more easing or delayed tightening to monetary policy, thus supporting local bonds in the region. Further out, trade relations with the UK and funding decisions by the EU are likely to pose greater downside threats to growth, yet uncertainty will likely remain for some time.

We see Turkey as potentially negatively impacted via trade and tourism with the UK and EU, which could be mitigated somewhat with improving trade ties elsewhere.

South Africa should be relatively insulated from the first order impact to trade, so Brexit is unlikely to weigh further on the current slowdown. However, should sentiment sour, South Africa is also the most vulnerable to financial contagion from the UK in a risk-off scenario.

Russia may paradoxically benefit from the decision, particularly if it bolsters its ties to the former Eastern Bloc while the EU manages the fallout from Brexit, assuming risk appetite remains robust and oil prices remain sturdy.

Outside of CEEMEA, links to the UK are small for most of LatAm and Asia, while they will benefit meaningfully from benign US monetary policy.

More generally, the perception that political risk in emerging markets is higher than developed market (DM) is being reconsidered, with meaningful implications for the relative pricing of assets.

After Brexit, DM growth (mainly Europe) has been revised down, with EM growth barely affected; the gap between EM and DM, which was already turning in favour of EM for the first time in 5 years, is likely to widen further.

More political and economic instability in DM will cause EM to reconsider their export-oriented model and force their economies to be more balanced.

With the below factors at play:

  1. Low direct trade links between EM and the UK
  2. Signs of stabilisation in China
  3. A benign outlook for US monetary policy

EM debt looks increasingly appealing relative to DM in the medium term. Moreover, if EM can maintain real productivity growth, fiscal discipline and continue to reform their institutions, they can also offer a much better long term investment prospect than low growth, indebted, QE addicted and now politically unstable Developed Europe.