An interview with Lena Sellgren, Chief Economist at Business Sweden. We asked Lena "how should investors manage the potential for volatility in EM?"

Pádraig Floyd, Consultant Publisher, Clear Path Analysis: To what extent is caution the watchword for emerging markets – especially debt and currency – in these volatile markets?

Lena Sellgren: I would say it depends which emerging markets it is you’re talking about. As the US$ strengthens, interest rates will go up, and if they are very correlated to the US debt and foreign exchange, there could be a risk for some of them.

As I see it, the risks are higher for some of the Asian and Middle East countries. You also have to take into account that China is moving into a more consumption-driven economy. We will see over the next year whether the Chinese market does experience slower growth – and whether the ongoing reforms will have an effect.

Aside from the US$, there are considerable tensions between the superpowers. This may not be a major concern, but it’s in the air and if there is conflict, there is risk.

Pádraig: What will be the influence of a stronger dollar, interest rate rises and geo-political turbulence?

Lena: It is a risk, as it means volatility. Of course, we can expect volatility anyway. The US economy will not deliver 6% annual growth, despite Donald Trump saying that recently. If we see a change to the tax regime, a boost in infrastructure spending and the Federal Reserve further raising the interest rate, we will probably see more volatility in emerging markets.

However, this again depends on the regions and how correlated they are to the US economy. I should say we will probably see other influencing factors, as there are elections coming up in 2018 in Russia, Brazil and Mexico, with the latter engaged in the latest round of NAFTA (North American Free Trade Arrangement) negotiations.

Pádraig: Should investors be optimistic that that EM debt and currency will generate the investment returns they need?

Lena: You should be careful and watch for the developments coming up in the next year. It’s hard to stay optimistic, but there is positive sentiment out in the global economy – most indices are above historic averages. Reforms in emerging markets continue and this is unlikely to deliver anything but positive implications for investors.

Pádraig: What opportunities do you see for EM debt and currency and what are the key dangers to avoid?

Lena: As I have said, follow the developments, including the NAFTA negotiations, as I think despite the rhetoric, we will end up with some co-operation there. Make sure you really try to understand as much as possible that is going on. Continue to follow the developments closely, as they could have major applications if things start to move.

Pádraig: Hard or local currency or both? What strategies might be pursued in EM debt and currency?

Lena: There is a very tricky question to answer. I looked at this before and it’s very difficult, because it could differ a great deal between different markets. It’s a very complex situation and you will be making a judgement on a country by country basis – not regional – and you should expect to use experts if you don’t have any in-house.

Pádraig: To what extent has EM debt and currency now become a mainstream asset class?

Lena: When it comes to the Swedish perspective, I don’t know to what extent that emerging markets and currencies are included, but currency is always certainly an element.

Pádraig: What do you think will be the key geopolitical influences in the coming year or two?

Lena: In the middle of 2017, we published a report called If Crisis Hits about the potential geopolitical risks across the world. In that report, we put together three possible, independent scenarios. The first scenario describes a grey zone conflict in the Baltic Sea region, with a territorial advancement by Russia as trigger point.

The second scenario is set in the Middle East. While there may not be a full-scale war between Saudi Arabia and Iran, there has been a breakdown in the countries’ political relationship. We are keeping a close eye on the instability in that region, and on the African continent.

The third scenario describes a superpower conflict between the US and China. This potential stand-off is what I’m most concerned about, although other larger regional conflicts also have the potential to dramatically affect the world economy.

For example, if things would deteriorate significantly in the Middle East, this would lead to a global fall in confidence by companies, investors and households. As a fragmentation of the region would also create large refugee streams, this scenario would have an extremely negative impact, particularly in Europe.

This interview is an excerpt from the Investing in Emerging Market Currencies & Debt 2018 report. You can download the full report for free online.