Emerging Equities: Good For the Long Run

Kevin Grice, American Express Bank Ltd., London.
This article appeared in the May 2008 issue of Current Economics with permission of the author.

Key Concepts: Emerging Markets | GDP Growth | Inflation |
Key Economies: Asia | Eastern Europe | China |

The credit crisis and US recession has hit emerging equities, and widened emerging market credit spreads, whilst some countries have suffered episodes of large capital outflow. But, in contrast to previous turmoil periods in industrialised countries, emerging market GDP growth has remained strong. The higher resilience reflects five factors.

Firstly, increased global economic integration has lifted emerging market productivity growth. Technology advances and transportation improvements have disaggregated production processes and, combined with labour market reform and higher education standards, have increased the use of previously unemployed or rural-based workers — especially in China, India, and Eastern Europe. Productivity gains have brought higher incomes, higher employment, and lifted household spending. The need to improve infrastructure has also increased investment. Finally, economic growth has become more intensive in its use of natural resources, boosting commodity prices and leading to the strong performance of commodity exporting countries in Africa, the Middle East, and in Latin America.

Secondly, external trade patterns have changed —emerging markets are increasingly sending goods and services to other developing countries rather than just to the industrialised world. Intraregional trade within Asia is especially important but trade corridors based on commodity flows have widened dramatically between Asia and Latin America, and between Asia and Africa.

Thirdly, emerging markets have mostly maintained disciplined macroeconomic policies which have brought down inflation, fiscal deficits and interest rates, and have helped lift domestic household spending and domestic business investment. Financial sector liberalisation has also increased the availability of credit and, together with on-going urbanisation and a growing middle class, has lifted home-ownership. In addition, structural reforms, together with governance and institutional improvements have enhanced the operating environment for business. Compared to the past, Latin America and Africa have more successfully leveraged the benefits of the commodities boom, and broadened their exports.

Fourthly, emerging markets in aggregate have become big exporters of capital and savings — a major contrast to the period before 2000. Government balance sheets have improved and businesses, given the hard lessons learnt from past crises, have become more cautious in taking on leverage and in boosting investment. External vulnerabilities have also been substantially reduced, as FX reserves have climbed and the reliance on foreign borrowing has dropped back.

Finally, the credit crisis has had little direct impact. Emerging market banks have virtually no exposure to the US mortgage problem. Bank finance, rather than capital market finance, is also by far the most important source of funding in emerging markets, and the banks have kept lending at affordable cost.

There are some concerns — in a few countries domestic credit and property price booms threaten bank balance sheets (in Eastern Europe, the Middle East). In some areas, large external deficits have also been mainly financed by volatile short term and debt-related capital inflows (also Eastern Europe). But, despite these pockets of vulnerability, emerging markets overall are now less dependent on the business cycle in industrial countries.

More Spillover to Come

Despite the improved resilience, we expect that weak growth in industrialised countries, and high inflation, will curb household spending and business investment in emerging markets and bring weaker GDP growth. But economic slowdowns should end up being moderate rather than dramatic. For the countries covered in this analysis, we forecast that real GDP growth will drop an aggregate two percentage points by 2009, down to around 6% per annum next year from 8.4% per annum in 2006-07. Emerging market growth around 6% per annum would be the weakest performance for five years but would still be better than in 2001 when the US economy was last in serious trouble.

Despite opening up their economies, foreign trade with industrialised countries is only crucial for a few emerging markets. Domestic demand is far more important and should slow rather than collapse. Unemployment is now generally in-line, lower, or far lower, than its recent average. Household spending as a percentage of GDP also remains well down on the typical OECD average of 60-65% (and the too-high US ratio of 70%), and should move higher over the long run as income and employment improves. Also, positive wealth effects from property markets should continue.

Business investment will also probably hold relatively strong. Investment as a percentage of GDP is higher than the US but developing countries are undergoing big structural changes, where reforms are throwing up new opportunities and infrastructure needs improving. Domestic investment is clearly too high, and needs to fall, in China. Elsewhere businesses have recently been cautious on spending, balance sheets are generally strong, and debt levels manageable. Overall leverage as a percentage of GDP remains low and should climb higher as emerging markets keep maturing.

Finally, emerging markets have plenty of policy flexibility to tackle any problems that come up. Real interest rates are low, FX rate over-valuation is far from generalised or extreme and government debt levels remain manageable — most countries can increase public spending should damaging GDP slowdowns look likely.

Valuations More Supportive

Price-to-earnings (PE) ratios have naturally been improved by the equities sell off, although PE’s have generally still to fall to levels which in the past have been a clear buy signal — typically to the very bottom, or below, a “reasonable” 10-20 range. The monetary policy tightening needed to curb inflation implies that PE ratios will fall further. But we believe that the 2008 inflation “shock” will be largely over by mid-year, and that later this year inflation will fall, bringing rates down as well and lifting PE’s.

Profits growth is likely to slow in 2008-09 as GDP growth slows and hits corporate revenues, whilst high raw material prices lift costs. But profit expectations are dropping to achievable levels — which we judge as being in-line with nominal GDP growth. Emerging market profits also shouldn’t suffer the sharp falls probable in the industrialised countries. Profits are not as structurally high compared to GDP, whilst high productivity growth and high commodity prices, should limit the downside and ensure that profits continue to climb.

Finally, liquidity flows should quickly become supportive once risk appetite improves. The prolonged period — 1-2 years — of below trend GDP growth we expect in the US and Europe should mean that institutional and retail investors in these regions will likely want to diversify more into emerging markets, Japanese institutional and retail investors will also likely continue to look for better returns overseas. The recycling of Middle East oil surpluses and Sovereign Wealth Fund activity should also help.

What Are the Risks?

A big inflation problem: Inflation is already a problem in emerging markets but could become more of a worry if commodity prices move higher still and/or monetary policies do not tighten enough to stop wages climbing and a wage-price spiral. High inflation can lift equities for a while but in the end is bad news — economies “overheat” and then suffer often painful and long adjustment periods of high rates, low GDP growth, and squeezed profits. Higher food prices could also bring more social unrest.

We expect commodity prices to stay high but to stabilise — which should eventually pull down headline inflation rates. Core inflation should move lower as well. The policy response has been good, whilst flexible labour markets, high productivity growth, and the still-large pool of under- utilised workers should hold down wages. Unemployment should also rise. The emerging markets at highest risk are Saudi Arabia, the Middle East Gulf states and Hong Kong, where monetary policy is constrained by US dollar FX rate pegs.

China suffers a “hard-landing”: We expect a China economic slowdown that is deeper than consensus forecasts. But we still judge a “hard-landing” — say growth slowing to 4-6% per annum — as being unlikely despite what will be a difficult 2008-09. Exports and investment will slow further but should continue to be offset by stronger household spending as incomes and employment climb and reforms improve the social security “safety net”, and reduce precautionary savings. China also has massive financial resources and the policy flexibility to respond if a “hard- landing” really does threaten, whilst the economic fall-out from any further Chinese equities collapse should stay minor.

The US recession goes global: The US recession could be far deeper than we expect, maybe even longer, which would hit emerging markets GDP growth much harder. The financial crisis could also deteriorate again rather than gradually stabilise, which is what we believe is most likely. In either event, US stocks would have much further to fall, and emerging equities would be pulled far weaker as well, and for a long time. The IMF rates the global recession risk as a 25% probability.

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