Emerging market disruption

The slowing growth of emerging economies puts a cloud over how much further Australian corporate profitability might rise.

Slowing growth in emerging markets has the potential to greatly impact the earnings potential of the Australian companies in the future.

Gone are the golden days of emerging markets consistently delivering economic growth, bolstering earnings of Australian companies. As the developed world continues to stabilise and find economic growth once again, growth forecasts for emerging markets continue to be revised downwards.

Beyond emerging market dramas the Australian market has to battle with domestic economic conditions that are not as healthy as experienced when mining was booming, and this is forcing investors to readjust expectations.

While other developed markets such as the US and Europe are finally returning to positive economic growth, it isn’t meaningful for the majority of Australian companies. Growth across emerging markets is far more significant as Australia’s economic fortunes are closely tied to the emerging world.

It is fair to say traditional top-down drivers spurred by emerging markets and the domestic commodities boom are no longer going to have the material impact domestic investors have been accustomed to.

This means profitability drivers for Australian companies will without doubt change. By historical standards Australia’s current corporate profitability margins are high, leaving little scope for improvement.

For profitability measures to improve from here it would require companies to experience increasing sales and domestic GDP growth. This looks an unlikely prospect if emerging market growth actually slows as much as forecast.

This is not to say stalling growth in emerging markets is going to ruin the prospects of the Australian market. It is evident cyclical stocks have continued to improve over the past couple of months, indicating lower interest rates are gaining traction within the economy. But a cloud remains over how much further profitability might go from here.

Problems with emerging markets are not solely endogenous to those markets – slower world growth in general has contributed to some of the issues they face today, along with country specific issues including the build-up of fiscal imbalances and current account deficits.

And pressures on emerging markets stem from the liability these markets face when developed economies move away from import-led growth. At the moment Turkey, India and Brazil all have larger account deficits than they did in the lead-up to the Asian financial crisis.

Large account deficits have the potential to be greatly problematic when the Federal Reserve does begin to wind down the current stimulus program and interest rates inevitably rise. It is easier to fund inflows when debt is cheap, but a much more difficult scenario when it becomes more expensive.

There is good news – improving global growth, regardless of which countries are responsible for delivering it is generally favourable to equities over bonds. 

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