For the better part of the past five years, we have highlighted the cyclical challenges facing emerging-market (EM) economies as a group. As expected, emerging-market stocks lagged those of the U.S. and other developed markets during this period. However, recent improvements in the global economy and EM business cycle trajectories have caused some cyclical headwinds to recede and the near-term prospects for many of these countries to improve.
Lingering challenges after a cyclical boom
The big story in EMs during the past few years has been the downshifting from rapid growth to a more moderate pace. While the EM category contains a wide variety of countries, there are a handful of common challenges that have defined this period and came to a head during 2015:
- The end of China’s boom—China is not only the largest emerging market but also the biggest external influence on the economic performance of many other EMs. In recent years, China’s thriving economic growth gave way to a credit-fueled investment boom that left it burdened with massive private leverage, severe imbalances, and overcapacity in the industrial and property sectors.
- Global trade and industrial recession—The ripple effects of China’s slowdown—both the excess capacity in its industrial sector as well as the drop in import demand—were the biggest contributors to the global trade recession in 2015. This downturn was defined by weak manufacturing and plummeting commodity prices (see chart). The effects have been felt most acutely in emerging-market countries, many of which are commodity producers or have close trade linkages with China.
- Financial pressures—As a result of these and other economic challenges, many EMs faced tighter credit and monetary conditions. Countries such as Russia and Brazil experienced steep declines in the values of their currencies and were forced to hike interest rates to arrest the rise in inflation. The Fed’s move to a rate-tightening cycle put additional pressure on global liquidity.
Global stabilization, base effect support EMs in near term
While some of these challenges have by no means disappeared, the near-term cyclical outlook has improved materially for EMs as a group. Global stabilization in 2016 would provide the backdrop to end the sharp declines in EM economies, commodity prices, and EM currencies. We believe the following cyclical changes are beginning to take shape as we projected:
- China’s stabilization—After a volatile 2015, policymakers in China have demonstrated a commitment to near-term stability, and have implemented substantial fiscal stimulus measures in order to support real activity (see Macro Update: China).
- Positive “base effect” of global stabilization—Steadiness in China has contributed to a reacceleration in global manufacturing activity, a firming in global trade activity, and a rebound in commodity prices. While these trends do not imply a rapid reacceleration back to boom times, they benefit from the ability to grow off a very low base.
- Improved cyclical outlooks in many EMs—Many EMs are now receiving support from a similar base effect. After settling at a lower level, there now exists an opportunity for an upside surprise for some countries in economic activity and corporate earnings growth. For example, after falling to a multi-year low in late 2015, our diffusion index of EM manufacturing activity has rebounded significantly over the past 10 months (see chart, above). Raw industrial prices have risen into positive territory on a year-over-year basis for the first time in more than two years. After corporate earnings declines of nearly 20% in 2015, growth is no longer deteriorating and expectations appear to have inflected positively.
- Easier financial conditions—The more-gradual-than-expected pace of Fed tightening in 2016, as well as additional global easing after June’s Brexit referendum, has allowed EMs to enjoy more favorable liquidity conditions. The recent rally in EM debt instruments has pushed yields down close to historically low levels, lowering the borrowing cost for EM sovereigns and many corporates.
While financial market turbulence can always rear its head, the principal risk to our positive near-term outlook for EMs is China. China’s stabilization has been heavily dependent on policy action, as demonstrated by the rise in government spending on fixed asset investment (FAI) alongside the decline in private-sector FAI (see chart).
Ultimately, China will need to enact structural reforms to clear out the excessive credit and industrial capacity, which will likely entail higher economic and financial risks. Similarly, we do not expect emerging markets as a group to experience a robust, early-cycle type reacceleration anytime soon. Many EMs share cyclical and structural challenges such as a credit overhang and overcapacity, and still face a long-term adjustment to a slower growing global economy.
Strong secular prospects for emerging markets
Beyond the cyclical outlook, we believe EMs have relatively positive secular growth prospects. We expect that over the next 20 years, EM countries will grow faster than developed markets (see chart, below), in large part due to faster labor force growth. In addition, several EMs with youthful demographics—such as the Philippines, India, and Indonesia—also have the benefit of considerable “catch-up potential” to grow productivity rates off a relatively low base.
The largest risk to this relatively rosy secular outlook is the potential for financial instability, particularly in China. Historically, growth-destroying financial crises most often occur after a large build-up of imbalances, and financial fragility is most pronounced in China and in EM Asia.
Asset allocation implication: Positive cyclical outlook for EM stocks
Our business cycle framework is founded on the principle that in the near and intermediate term, asset prices are influenced more by the change in the rate of growth rather than the level of growth itself. In other words, over the next 12 months any improvement in cyclical trends in EMs is likely to outweigh investor concerns about the diminished pace of absolute growth relative to the prior global boom period. As a result, the fundamental improvements we are observing— especially relative to low market expectations—have made us more positive on EM stocks during the course of 2016 than at any point during the past few years. Positive drivers for EM equities include:
- U.S. business cycle outlook: Historically, EM stocks perform well on a relative basis during the U.S. late cycle, partially due to commodity-exporters benefiting from a pickup in inflation and rising commodity prices (See United States: late-cycle indicators elevated, recession odds remain low).
- EM business cycle fundamentals: The corporate earnings outlook has improved, with profit growth trends improving and turning positive in countries such as Brazil, India, and Mexico (see chart). According to our business cycle models, China has stabilized, Brazil has entered the early cycle, and India’s mid-cycle expansion continues (see Global: Stabilization continues despite Brexit risk).
- Foreign exchange (FX): Our analysis indicates that many EM currencies are either at fair value or undervalued relative to the dollar, and we anticipate that FX will no longer be a headwind for USD-based investors in the near term.
- Secular drivers: Over the long term, strong growth prospects and more attractive valuations relative to developed markets make EM equities a key component of a global equity portfolio.
Business cycle: macro update
The U.S. and global economies have continued to gain momentum despite post-Brexit headwinds. The U.S. continues to experience a mix of mid- and late-cycle dynamics with low odds of recession, while the global economic expansion continues at a slow but steady pace.
United States: late-cycle indicators elevated, recession odds remain low
Consumer supports continued expansion
Favorable employment conditions have helped soak up a significant amount of excess slack in the labor markets. Hiring remained solid in July, although the pace of gains has decelerated—as is consistent with historical late-cycle dynamics. Wage pressures remain in an uptrend and continue to support consumer spending, particularly for housing.1 Both core and headline inflation measures are poised to end 2016 above 2%, as the uptrend in wages is keeping core inflation measures firm while oil prices will soon begin to lap late 2015’s subdued levels. Tight labor markets and rising income suggest that the U.S. consumer is providing a solid foundation for continued U.S. expansion.
Mixed outlook for business sector
Stabilizing external conditions have helped the U.S. business sector regain footing from the recent slowdown. The reacceleration in industrial activity, as well as fewer headwinds from oil prices and the dollar, suggests an opportunity for earnings to surprise to the upside in the near term. In fact, second quarter S&P 500 earnings appear to have risen for a second consecutive quarter in Q2—the first time since mid-2014.2 Late-cycle trends continue to build, however, with banks further tightening lending standards for businesses.3 Moreover, rising wage pressures are likely to begin weighing more heavily on corporate profit margins. The corporate sector is experiencing a modest upswing, but late-cycle trends are likely to cap the upside.
Global: stabilization continues despite Brexit risk
U.K. recession risk elevated post-Brexit
Brexit increased the risk of recession in the U.K, although so far the impact on real economic activity has appeared limited. Business investment expectations and consumer confidence turned sharply lower in the weeks after the referendum, but consumers remain resilient amid a healthy jobs market, and the policy response from the Bank of England could hold off a sharp contraction. Political uncertainty from the Brexit aftermath remains a headwind for business investment, but the household sector is underpinning the UK’s late-cycle expansion.
Europe: Expansion on track despite Brexit headwinds
The euro area remains in a mid-cycle expansion phase, benefiting from a stronger manufacturing sector and improving credit conditions. The French consumer sector appears buoyant; easing German mortgage conditions signal a potential reacceleration in construction; and the probability of recession in Italy has declined alongside concerns about its undercapitalized banking system. European economic sentiment indicators have, so far, been little changed following the Brexit vote (see chart). Europe’s domestic economy appears strong enough to continue its tepid cyclical expansion despite rising political uncertainty.
China: stabilizing amid fiscal response
A downshift in growth at the end of an overextended credit boom has caused China to remain in a growth recession for the past year, but the economy has steadied during the past several months. Recent economic stabilization can largely be attributed to a strong fiscal policy response that has supported the industrial and property sectors. After declining for the past four years, producer prices have started to flatten, signaling the worst of the deflationary phase could be passing. China appears to be nearing the end of a growth recession, but greater structural reforms will likely be needed for a sustainable reacceleration.
Brazil: entering an early-cycle recovery
Brazil is showing signs of exiting one of the most painful recessions in its history. While sentiment indicators remain at relatively low levels, their sharp improvement in recent months is a classic sign of an early-cycle recovery. Inflationary pressures have recently decelerated, although year-over-year price growth of 9% is keeping the central bank from cutting rates from a still restrictive level of 14.25%. Recession probability indicators have declined sharply, but lower inflation and a shift toward monetary easing are likely needed to generate a sharp acceleration in growth.
India: high relative growth with improvements on the margin
With limited exposure to Chinese trade demand and as a net beneficiary of lower commodity prices, India’s economy was able to weather the global slowdown of 2015 better than many EM economies. India is in a modest mid-cycle expansion, helped by steady improvement in its industrial and consumer sectors. Monetary easing from 2015 is beginning to have a positive lagged impact on credit conditions. Economic growth remains relatively high and stable, but does not appear to be in a position to accelerate meaningfully.
Global summary: stabilization continues
Most post-Brexit data show the global economy continues to modestly reaccelerate across a variety of metrics. Roughly 70% of countries’ manufacturing bullwhips—leading indicators for manufacturing activity—were in expansionary territory in July. Japan has begun to recover from a mild recession, underpinned by improvements in the consumer sector. Policymakers announced a large stimulus package in July, but the size of the impact remains to be seen. Commodity-exporting countries such as Canada and Australia—as well as major China trading partner South Korea—remain in late-cycle expansions and continue to improve incrementally alongside China’s stability. The tepid global economy continues to gain cyclical traction.
Outlook/asset allocation implications
The post-Brexit spike in market volatility has been followed by several weeks of summer calm. The shift to a more accommodative monetary stance by major central banks likely played a large role in this turnaround. However, the resilience of the global economy in the face of another headwind has probably also been a factor, and incremental signs of global stabilization continue to build. These trends are particularly noticeable among many of the EM economies, even if a return to vibrant growth is likely to remain elusive.
Consistent with our business cycle view that asset prices tend to respond to cyclical improvement, we continue to favor global equities. In particular, EM equities still enjoy the benefit of low growth expectations and relatively attractive valuations. The rising probability of a U.S. shift into the late-cycle phase suggests market volatility could return and that smaller cyclical asset allocation tilts may be warranted at this phase of the cycle. A move toward late-cycle dynamics would also tend to favor assets that benefit or are more resistant to inflation, including EM and energy-sector stocks, TIPS, and shorter-duration bonds.
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