Emerging markets: marching in time with global parameters

Market analysis - 8/31/2016

Equity benchmarks are largely disconnected from local fundamentals. They march in time with the dollar and US interest rates instead.

The emerging stockmarkets are often regarded, rightly or wrongly, as harbingers of trends in macroeconomic variables. If they did have this predictive power, the recent run-up in share prices across most countries in this category would portend a marked improvement in the underlying economies’ fundamentals after five years fraught with severe structural difficulties.

The latest leading indicators are in line with our macroeconomic forecasts. Growth in the emerging regions as a whole is expected to gain pace in the latter half of 2016 after bottoming out in the second quarter. While encouraging, this outlook needs to be put in proper perspective. Most of the upturn will be led by accelerating expansion in the weakest economies: Russia, Brazil and South Africa. After sinking to -0.6%, -5.4% and -1.2% respectively in the first quarter of the year, GDP growth in these countries is benefiting from a recent bounce in commodity prices that will shore up their current-account balances. Two other countries, Malaysia and Turkey, which have large borrowing requirements, are being helped by the glut of liquidity created by central banks around the world.

Meanwhile China and India, the emerging heavyweights, will not see their GDP growth rates stray much current levels. Fuelled by robust domestic activity and remarkable progress in the area of structural reforms, India is the emerging world’s main driver with expansion clocked at a sizzling 7.9% last year. But China, with a long-term plan aimed at rebalancing its economy, has slowed its pace down to 6.7%.


The upswing expected in the weaker emerging economies, along with the relative stability in India and China, will combine to boost the bloc’s overall expansion in the second half of 2016. This breakdown will moreover continue to shape growth throughout 2017 as well, since China accounts for almost 50% of overall GDP and thus casts a very long shadow. Beijing leveraged growth in the first half of this year by encouraging borrowing, but with a rising tide of non-performing loans in its banking sector and a debt-to-GDP ratio that has soared to 255%, lending in the People’s Republic is set to slow of its own volition. Growth in bank loans has already slackened to 10.9% year on year (from 12.5% in March) and the authorities have resorted to more restrictive measures lately, such as keeping key interest rates unchanged and clamping down on shadow banking. In industry efforts to reduce overcapacity will eventually pay off, but in the meantime they are weighing on growth and will raise the issue of finding new jobs for idled workers. In this context there is little likelihood of a strong, sustainable economic recovery in China and, thus, in the emerging bloc as a whole.  

After leading their economic boom of the 2000s, international trade no longer provides much of a leg up for the emerging countries. Positive momentum in the developed world is not benefiting their exporters to any great extent. Depressed capital investment in the US, Europe and the emerging regions themselves has dimmed the prospects of countries, chiefly in Asia, that export manufactured goods (see left-hand chart below). Moreover, the offshoring of production facilities to China has reduced Chinese demand for imported goods, mainly from other emerging countries. From a structural standpoint, expanding services generally means fewer imports of equipment, thereby changing the momentum of global trade.


Actually, the impetus of the emerging upturn stems more from exogenous factors (the rebound in commodity prices, easing borrowing terms and a weaker dollar) than from a genuine rise in organic growth. This is true in the corporate sector as well, where growth in revenues and earnings is extremely low (see right-hand chart on previous page). Up to now the improving international outlook has provided scant benefits for emerging companies, prompting investors to eye these regions warily.

Knowing this, the hefty returns chalked up recently by emerging markets is puzzling. On the face of it the turnaround in equities stems more from warming sentiment, and from hunger for added performance in a liquidity-laden environment, than it does from a significant, sustainable improvement in these economies’ fundamentals. While emerging stocks remain comparatively attractive in terms of valuation ratios, they are also highly dependent on trends in external variables. For example, dollar appreciation or rising US interest rates could put an end to the current run-up (see charts below). This has already been illustrated by the more hawkish tone of Fed officials at the Jackson Hole conference.




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