|Summary: There is a consensus view that emerging markets are in a ‘Great Deceleration’, struggling to maintain economic growth due to structural changes. But many emerging markets, including China, are still in a strong growth phase, and investors should prepare for them to outperform developed markets.|
|Key take-out: The US growth story is boosting domestic stocks and will continue to support emerging markets with the greatest exposure, i.e. Mexico, Brazil.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
There’s been a lot of analysis recently about the emerging market story, not much of it good. For instance, The Economist magazine recently ran a headline about the ‘Great Deceleration’, although the IMF and even the Financial Times have taken up this cause as well – all with a similar diagnosis.
The gist is that the ‘Great Deceleration’ will mean that the emerging markets will no longer be able to make up for weaker growth in the advanced economies.
By the way, the definition of emerging market is quite broad, and generally refers to countries undergoing rapid growth, urbanisation and industrialisation etc. That’s roughly 25 countries, give or take, covering most continents and up to 80% of the world’s population. Think the BRICS – Brazil, Russia, India, and China – but other large economies include Mexico, Indonesia, Argentina, and in Europe, Poland.
Shane Oliver last week made his case for a slowdown in emerging markets in his article Time to go global. The story is that the emerging economies will slow and so global growth will slow, perhaps even struggle. For Australia, this is critical because, and as I highlighted in my May 6th piece Australian growth a developing story nearly two-third of our trade is done with emerging markets. It matters.
At the outset, there is one immediate, and very strong rebuttal that I have made consistently over the years – one that has made considerable traction lately. That is, slower rates of growth in the emerging world don’t matter – and indeed are desirable. These economies are so much larger now, that just on the math, slower growth rates provide more momentum for the globe, than double digit growth rates did when these economies were smaller. China’s economy, for instance, has nearly doubled in size since the GFC. An $8-9 trillion economy growing at 14% per year would be disastrous for the globe. Too big, too fast. When China was a $2-3 trillion economy all the way back in 2006-07, 12-14% growth rates were just manageable. Not now.
Confusing structural changes with cyclical policy settings
This of course highlights the key problem I have with the view of the IMF and others – the consensus really. They confuse, or perhaps over-emphasise, structural changes, such as China’s rebalancing, in slowing growth. Take a look at chart 1 below. It shows the official cash targets or interest rate settings of select central banks in the emerging world. They are on the whole in restrictive territory – and there is a very good reason for that. The simple fact is, with growth still quite strong, the policy settings of many economies in the emerging world are geared to either tackle an inflation problem, or, in the case of China, avoid the development of one.
More generally, there are many good reasons to continue to doubt this much-vaunted China rebalancing act. I know this is the rhetoric, even officially from China. However I don’t think it’s the reality. Indeed, I doubt very seriously that China even truly wants is. Why? Because investment-driven, export-led growth is a successful business model – a model to which the US and UK now aspire – one to which the Germans always have. Why would China want its citizens to embark on their own consumption binge, exacerbating already existing social divergences and perhaps fracturing social hegemony? This is not something they want to do as a matter of policy. That’s not to say China doesn’t want consumption growth and a prosperous citizenry; they do, and the reality is consumption growth in China is already very strong. But they want this growth as a consequence of strong investment and export growth. Not the force fed, debt driven binge that drove the US into the ground.
There is a broader political agenda here. The US has often complained that it’s consumers have been the bulwark of global growth and that other countries have not been pulling their weight. This is why you hear so much about global imbalances. This global imbalance is alleged to have manifested in many ways – eg. the large US trade deficit, especially with China and high US consumer indebtedness. Indeed the chairman of the Federal Reserve, Ben Bernanke, argues that the ‘Asian savings glut’ was a key cause of the US sub-prime mortgage crisis and thus the subsequent global financial crisis.
The idea was that this glut of savings then flowed into the US (bonds etc.), creating a capital account surplus, and lower interest rates than would otherwise have been the case. This then led to a US consumer debt binge, a house price and construction boom etc. There are three obvious flaws to this view. Firstly, it was the Fed who kept interest rates too low for too long. Moreover, Asian savers didn’t force US consumers to borrow money and nor did they have any say in the lax lending standards and US regulatory failures of the day. Don’t forget that the US made similar complaints against Japan and West Germany in the 80s, forcing massive currency revaluations on both economies, which of course led to Japan’s lost decade – and no material change to the US trade deficit I might add.
However, this is the public policy backdrop; it is what US policymakers actually believe, and it is critical to bear it in mind if we are to truly understand the latest rhetoric on the emerging markets. To my mind, this obsession with China’s as yet non-existent rebalancing, more reflects wishful thinking by policymakers – a desire to impose it – and a bit of diplomatic lip service from the Chinese. China wants to force a rebalancing like the US wants a strong dollar – like Japan wants an exchange rate determined by the market! (i.e. not at all, yet all publically proclaimed). Think of it as the propaganda component of the very real currency wars underway.
So we know as fact that emerging economies have had slower growth – not too much slower mind you. Chart 2 shows growth has been, and continues to be, quite strong – little changed from historical averages.
Yet, as discussed, this isn’t the symptom of some precarious re-balancing act. Instead, the emerging economies have been working hard to contain the inflation pulse that loose monetary policy elsewhere has caused.
This is why merging market earnings have disappointed, and why emerging market stock indices have underperformed global indexes. Noting this, there could be some very good news for the emerging economies, who would otherwise have their own positive story to tell, and one we know well: Ongoing urbanisation and industrialisation.
As I noted in my piece of July 26, A Red flag for commodity investors, US regulators have started to clamp down on the commodities market. If they persist and are successful, this will have a material impact on global inflation, especially for the emerging markets. Remember that commodities – food stuffs oil etc., – form a much higher proportion of the inflation basket in emerging economies (30-40%) than they do in the advanced economies (between 5% and 15%). This would in turn free up policymakers in the emerging world to take their foot off the brakes – to stimulate growth.
The two clear implications from this are that investors should prepare for the emerging markets and emerging stockmarkets to outperform developed markets. Secondly, that being the case, any idea that Australia is threatened by the ‘Great Deceleration’, is wide of the mark.
So then, which markets? Remember that the emerging markets are a diverse group. Not one homogenous country. Well, in addition to picking those countries with sound domestic growth prospects , hindered largely by inflation, eg. the BRIC economies, I would also look at those most leveraged to the both the US and China expansion.
As I suggested to readers earlier this week, the US growth story is boosting domestic stocks and will continue to support emerging markets with the greatest exposure, i.e. Mexico, Brazil. Add to this Indonesia, Vietnam and the Philippines. These would be my preference over some of the European economies (eg. Poland, Czech Republic), to whom the above arguments are less relevant. Growth, not inflation, is more the problem in these economies and rates are already low.