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Throughout 2016, the increasing strength of the U.S. dollar will deepen the divide between emerging markets that do and don’t depend on commodities.

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This will occur because interest rates in developed markets are set to rise, with the Federal Reserve driving that trend, says Michael Reynal, portfolio manger at RS Investments in San Francisco, Calif. RS Investments sub-advises the Renaissance Emerging Markets Fund.

“The U.S. dollar is likely to remain strong versus the euro [and] the yen, and especially versus commodity-linked currencies,” he adds. As such, emerging markets tied to commodities are likely to suffer from weaker currencies and terms of trade, and from higher inflation and interest rates.

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By contrast, says Reynal, countries such as India, China and Mexico will be more insulated. “[They’re] not as reliant on commodity exports. And, broadly speaking, [they] have stronger current account positions, less pressure on [their] currencies, and [are] less likely to see inflationary pressure.”

Further, he notes, “These economies are likely to have flat [or] slightly upward-trending interest rates.”

Read: Global economy to remain fragile in 2016: Vanguard

Dip in international trade?

Another issue that will weigh on commodity-reliant economies is the potential decrease in trade that occurs between developed and emerging markets. “We see this everywhere. This has not just been driven by currency strength and weakness, or by pickups in technology.” In fact, Reynal’s seeing shifts in trade in the U.S., Europe, Japan, China and Latin America.

Considering we’ve just come through two decades of increasing trade, he says, “this is a big shift, and I worry that it could be long-lasting.”

Read: Are emerging markets worth the risk?

“What this means for [emerging market] growth next year is that [it’s] going to be relatively muted at 4.5%, [which] leads to likely earnings growth for the year of roughly 10%. [That’s] not a bad number, but it’s not the spectacular number we would have seen earlier in the decade.”

Markets are expecting a rebound in cyclical sectors such as materials and industrials, but Reynal is skeptical. “We’re not yet seeing a pickup in demand in China or in the U.S. for commodity-type products. But, earnings growth is likely to remain strong [in] the consumer staples and consumer discretionary sectors,” as well as in the healthcare and industrial spaces.

Political risks

Investors should also keep an eye on emerging market politics, says Reynal.

Brazil is facing tremendous political challenges, he explains. And, there has been “increased turmoil in Saudi Arabia and the other Gulf countries. This will prove to be problematic.”

On the upside, he adds, the political situations in China and India have stabilized.

But, Reynal predicts Russian politics could become more of an issue in 2016. “Putin’s hold on power remains strong, but we have seen already in the last few years a repeated push and repeated calls for a change in regime.”

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Originally published on Advisor.ca

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