Wednesday, August 26, 2015

Is it really that bad in the emerging economies?

A significant correction is underway in global equity markets with concerns about emerging market growth, in particular China, at its epicentre.  We think emerging economy growth fears are overdone and that this correction will eventually sow the seeds of a recovery, but the correction may have further to run in the near term.

The prevailing wisdom in emerging economies has been dominated by positive demographics, absorption of new technologies, fast rising productivity growth and the burgeoning growth of the middle classes would lead to transformational growth.  Today concerns reflect a confluence of cyclical headwinds, renewed concern about structural impediments to growth and higher leverage given impending US Federal Reserve rate hikes.  All are taking their toll on emerging market sentiment and asset prices.

The latest bout of weakness can be sheeted home to the recent devaluation in the Chinese Yuan (CNY).  We see this as a pragmatic move that was not about competitiveness and gaining export market share – China has been hugely successful at building market share even with a rising exchange rate.  The CNY devaluation was mostly about the desire for a more market determined exchange rate given aspirations of inclusion in the IMF’s basket of foreign reserve currencies.

We are not in the China hard-landing camp.  China is going through a challenging transformation as growth slows from unsustainably high levels, the economy rebalances from investment to consumption and its financial markets are liberalised.  This will inevitably lead to the occasional wobble, but long term we remain of the view that a slower China is a more sustainable China.

With respect to the emerging economies more generally, the once optimistic outlook has now seemingly been replaced with the overly pessimistic.  The headlines are now screaming about the need for structural reform in the emerging world.  This is not a new story, Regular readers know that since the GFC we have written about the need for transformational structural change in emerging economies to realise the opportunity presented by such positive factors as fast growing working-age populations. 

Neither is structural reform a story that is exclusive to the emerging economies.  Structural reform is needed everywhere.  You say Brazil and Russia, we say Italy and Japan.   In reality it is some of the emerging economies that are embracing reform better than many developed economies.  We put India, Mexico and even China into that bucket.

Overall we remain optimistic on emerging market growth and in particular their ability, on average, to outpace the growth of developed economies.  The reasons are the same as they were before – positive demographics, technology enhancing productivity growth and growing middle classes.  But structural reform is needed if those opportunities are to be realised.

Right now comparisons are again being made to the 1997/98 fallout in emerging markets.  As we said at the time of the taper tantrums in 2013 – this is not a repeat of that period.  Notwithstanding their own idiosyncrasies, we believe most emerging economies are generally in better shape now than they have been during previous episodes of rising US interest rates. 

It’s the reform agenda embraced by many emerging economies following the Asian Financial Crisis that we expect will see many of them come through the next round of higher US interest rates better than they have before.  Those reforms include more flexible exchange rate regimes, lower levels of external debt, higher levels of foreign reserves and better capitalized banking sectors.

In the immediate term US dollar sensitivity is being cited as the major negative for emerging markets.   EM currencies have been falling, most notably against a rising USD, but also on a real effective exchange rate basis. Ultimately a weaker currency will improve competitiveness and profitability of the tradeables sector.

What may be needed to end the negative feedback feeding through global currency and share markets at the moment though is a policy easing. This came in 1998 with the US Federal Reserve easing monetary policy. We can’t rely on that this time.  But it will take a decisive easing of liquidity/financial conditions for the risk premium to be priced back out and as we have seen over the past few years, when the flows come back they come fast.

The circuit breaker policy easing this time around ideally needs to come from China and it started last night with cuts to interest rates and the required reserve ratio.  Keep an eye out for more.