The direct economic impact of Brexit on broad emerging market equities should be limited, as exports to the European Union account for only 4% of emerging market GDP, according to a research note from JP Morgan Securities.
For example, the impact on emerging markets of Latin America is expected to be modest, as the share of exports to the UK and the European Union is low. But rising risk premia would likely hurt the highest beta equity markets and sectors in the short-term, which include Brazil’s energy, financials and materials and Colombia’s energy and consumer staples, the bank said.
On Friday, the MSCI Emerging Market index (-3.5%) outperformed the developed markets (-5%), and the developed market foreign exchange volatility was high with sterling falling 8%.
“The macro drivers for emerging markets’ outperformance are lower policy rates, end of falling commodity prices, a rangebound US dollar and economic stabilisation in China. We believe Brexit does not significantly alter these drivers."
The firm expects more accommodative monetary policies to be adopted by the European Central Bank and Bank of England, while the Federal Reserve is likely to delay its next rate hike to December, indicating that there is more room for central banks in the emerging markets to cut rates.
The global equity strategy team maintains an overweight on emerging markets as a whole. Specifically, overweights are China, India, Indonesia, Korea and Russia and underweights are Malaysia, Taiwan, Mexico, South Africa, CE3 (Poland, the Czech Republic and Hungary) and the MENA countries.
For emerging markets in Asia, a weaker euro and sterling are headwinds for exporters, particularly in Taiwan and South Korea. The EU is also India’s second largest trading partner and Indian IT services have significant exposure to the UK and the EU, the report said.
The markets did not price in Brexit, the bank said. "Investors may now seek [equities with less risk] approaching political events. Potential discussions around free trade agreements and US election could hurt open economies like Mexico,."
Impact on China, Asian currencies
Bank of Singapore said following the dramatic decline in the sterling following the Brexit vote, it has little confidence in calling the bottom in the sterling.
The sterling could yet trade down to $1.25-$1.30 in the near term, as valuations need to adjust sharply before the currency is seen as "too cheap", it said.
The bank said it is also important to watch for the reaction of policymakers in China to the dollar strength amid recent indications that the Chinese economy may once again be losing momentum.
"International investors and global policymakers alike are likely to prefer that Chinese policy play a stabilising role by restraining higher USD/CNY fixing. If China does not do so, the risk of headwinds could get stronger for Asian currencies."
China's renminbi weakened only 0.91% on Friday, but analysts are expecting China's RMB and other regional currencies to see selling pressure after Brexit.
The emerging markets sector has outperformed the MSCI EM index and the S&P 500 this year, according to FE Analytics.