The Demise of Emerging Markets Has Been Grossly Exaggerated
The recent selloff in Emerging Market (EM) currencies and rates has generated a market narrative that the EM cycle may already be over. We think this view is premature and believe that the current global growth cycle is intact and stable at fairly high levels of growth. It remains our opinion that growth has plateaued at robust levels, and the market reaction is one of reassessing the future winners and losers in this environment.

In addition to reevaluating the trajectory of growth, the markets are also digesting some idiosyncratic shocks, particularly on the trade front with the increasingly vitriolic dialogue between the United States and its major western trading partners, as well as from some smaller, more transitory shocks, like the new populist government in Italy and the upcoming election in Mexico.

In our last Quarterly Outlook,we expected global growth to remain solid, stabilizing at a level above its long-term trend. We also anticipated more differentiation among emerging markets on the basis of their idiosyncratic political and economic cycles. We see the recent market reaction in some emerging markets, such as Turkey and Argentina, as validating this view.

So far Q1 2018 was weaker than expected in the European Union and Japan, while U.S. growth continued at a solid pace. In our view, there appear to be several temporary and one-off factors that may have contributed to the slowdown in Europe. But make no mistake; growth in developed markets (DMs), including in Europe and Japan, is still above its long-term trend. Looking forward, we think it would be a stretch to expect further acceleration of growth from DMs where output gaps have been closing for several years now. Recent political developments in Italy unnerved the markets over the past few weeks. The new Italian government, formed out of two populist parties, plans to increase expenditures and cut taxes. The current proposals add up to a large fiscal deficit and will need to be tamed down but until the dust settles, it is safe to assume that increased uncertainty will pose risks to investor sentiment and growth in the next quarter.

A broader trade dispute is another cloud hanging over the horizon, but we continue to assign a low probability to a sustained escalation of measures and see the impact of recent U.S. tariffs on steel and aluminum imports to be limited. Nonetheless, we expect the continuous uncertainty to extract a toll from investor sentiment globally.

As for emerging market economies,  Q1 2018 data indicate growth held up well so far with several upside surprises coming from Asia and Latin America, with the exception of Brazil. Indeed, out of 17 EMs that reported Q1 GDP data, 12 had faster growth than they did in the last quarter of 2017. In the aggregate, globally, the world economy is still expanding above it long-term trend for now and EMs, who joined this party late, are still leading this trend. We forecast global growth will be slightly lower for the year than it was in 2017, as some steam gets let off the DM growth engine, and EM growth stabilizes at slightly lower levels.

Going forward, the growth outlook in EM hinges on two key global factors, overlaid by their domestic political idiosyncrasies. First, we remain concerned about tightening of financial conditions across EMs in response to rising U.S. rates, in particular rising real rates. On the positive side, the expected increase in U.S. import demand, driven by stronger growth from fiscal steroids, will be supportive for emerging market economies. This should offset, to a large extent, the impact of financial tightening. Overall we view the rise in global rates as a reflection of policy normalization in the context of strong global growth, notwithstanding the broader secular decline in interest rates.

Exhibit 1: Financial Conditions Have Been Tightening

The Goldman Sachs Financial Conditions Index (FCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable. An increase in the Goldman Sachs FCI indicates tightening of financial conditions, and a decrease indicates easing. The index is set so that October 20, 2003 = 100. The index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict performance of any particular investment.   Past performance is no guarantee of future results.

The second globally relevant factor is China, which is a key driver of external demand for emerging markets, given the increasing size of its domestic market, its impact on intermediate goods demand because of its oversized role in the supply chain, and it sizable demand for commodities. Our expectation has been a gradual slowdown in China, with growth coming down from 6.8% in 2017 to the 6.5%-6.6% range in 2018. (For more on this topics, see the recent “Silent Revolution in China” blog.). This change would be driven by a mixture of policies that tightened housing market and infrastructure investments, while continuing to strengthen financial regulation to induce an orderly deleveraging. The recovery in private investment and solid consumption would offset some of the tightening in the “official” sector. While this theme has been playing out in policy circles, our recent trip to China in late May confirmed our view that the policies will be tapered, if necessary, to underwrite growth and stability. Indeed the recent uncertainty generated by the U.S.-China trade dispute clearly got the attention of the policymakers, and they moved to a more neutral bias in monetary policy and relaxed some of the constraints on infrastructure projects to limit risks to growth. We consider this move supportive of EM economies and commodities in the short term. Furthermore, the decision to reduce import tariffs would further boost the prospects of EM exports to China.

Despite this positive global backdrop, the domestic political cycles in EM countries will still be a key differentiator of their growth. For instance, while we upgraded our growth forecasts for Asian EMs by a quarter percentage point to about 6.25% on the back of recent strength in data, we downgraded our Latin America growth forecasts by a half percentage point to about 2.3%, on the basis of developments in Brazil and Argentina. Brazil’s growth has been hurt by a weaker government and political uncertainty, while that of Argentina’s has been impaired by increasing macroeconomic imbalances that have generated a mini-currency and credibility crisis.

How About Emerging Market’s Vulnerabilities?

There is not one single economic variable that can summarize all the vulnerabilities an economy can face. These vulnerabilities include domestically generated credit and housing bubbles, debt overhang, low level of foreign currency reserves, or reliance on hot money flows, among many others. The breadth of issues to be considered explains why we look at a spectrum of metrics. And they show that this is clearly not 2013 or 2015. First, several emerging market countries’ external vulnerabilities are lower today than they were during the taper tantrum, when the U.S. Federal Reserve first signaled its intention to exit from its all-time accommodative monetary policy stance. During this period, and following the collapse of commodity prices in 2014-2016, emerging market economies went through major economic adjustments. Fiscal deficits have been reined in with tight policies that helped reduce inflation, and along with these changes current account deficits declined. In the process these same emerging markets increased their resilience to external shocks and reduced their domestic imbalances. For others, the adjustment was more cyclical than structural. Now, with rising oil prices and increasing U.S. yields, this differentiation is coming to the fore. Turkey and Argentina, the new “Fragile Two” are clearly examples of this differentiation, in which current account deficits have actually deteriorated during this time and reserve coverage ratios deteriorated.

Exhibit 2: Current Account Balances 2017 vs. 2012

See footnote 1 for a key to country abbreviations.

As for leverage, the picture is mixed for several reasons. First, while most Asian EMs reduced their total debt (except for China), debt as a percentage of GDP went up among Latin American and Central European emerging markets. Nonetheless, the total non-financial sector corporate debt (excluding the oversized Chinese non-financial corporate debt) has been coming down from its peak in 2015, and overall debt growth now is below nominal GDP growth across the emerging markets – conditions that both make growth less reliant on debt and existing debt more affordable.

Second, we are in the recovery stage from the commodity slump. Commodity prices collapsed by an average of about 50% during 2014-2015, while they have been growing at a healthy clip since mid-2016 and have not budged since the beginning of the recent market turmoil. That means EM countries that rely on commodities can look forward to a modest improvement in their terms of trade, and that set of circumstances should help their external and fiscal dynamics and growth prospects. 

More broadly, improving global trade─ both in volume and price terms─ has been a critical factor behind the recovery in EM growth over the past two years, after a prolonged period of below-trend world trade activity. While we expect the super fast pace of EM exports, partly driven by the consumer electronics cycle, to moderate, we think this change will be more than offset by recovering investment demand globally, and that should support healthy trade volumes.

Third, the recent selloff was concentrated in EM currencies on the back of dollar strength while EM nominal rates barely moved when compared to 2013. (See Exhibit 3) Indeed the selloff in EM currencies was bigger than it was in 2013, although valuations were cheaper than they were at the onset of the taper tantrum. (See Exhibit 4). Furthermore, real interest rates are much higher than they were in 2013. (See Exhibit 5). We see this correction opening up new opportunities in the EM space as our medium-term view on dollar weakness on weak fundamentals remains intact. As we stated in a previous blog, the path toward a weaker dollar need not be a straight line. When U.S. growth and inflation surprise on the upside, the dollar may continue, as recent data have shown, to appreciate for a short period.

We continue to believe that in the current environment, EM fixed income investments will remain attractive, while country-specific stories are likely to be more important in driving relative performance. The market has changed the valuations of our base case, but as always consistent with our investment philosophy, we stand ready to take advantage of market opportunities when the pricing of our scenario changes materially.

Exhibit 3: Change in 5-Year Nominal Interest Rates

See footnote 1 for a key to country abbreviations.

Exhibit 4: Real Exchange Rates

See footnote 1 for a key to country abbreviations.

Exhibit 5: Real Interest Rates

See footnote 1 for a key to country abbreviations.

1. In Exhibits 2 to 5, the country abbreviations stand for: AR : Argentina; BR - Brazil; BRL -  Brazilian real; CL – Chile; CLP - Chilean peso; CNY - Chinese Yuan; COP - Colombian peso, CZK: Czech koruna, EM FX is the EM foreign currency or exchange rates; HUF - Hungarian forint; IDR - Indonesian rupiah; ILS - Israeli shekel; INR  Indian rupee; KRW - Korean won; MXN - Mexican peso; MYR - Malaysian ringgit; PE- Peru; PEN : Peruvian sol; PHP -Philippine peso; PL – Poland; PLN - Polish zloty; RUB - Russian ruble; SGD - Singapore dollar, THB - Thai baht, TRY Turkish lira, TWD Taiwan dollar, USD – US Dollar; ZA – South Africa; ZAR - South African rand