Latest Emerging Markets (Unconstrained) economic and market outlook.
Despite stubbornly low inflation in the developed world, central banks are acutely aware that interest rate policy remains too close to the effective zero bound. Indeed, central bank balance sheets are very large in comparison to historic ranges, interest rates are exceptionally low, and government debt-to-GDP is very high. In short, there is precious little ammunition to deal with downside shocks. Consequently, the Fed will likely tighten further over the coming quarters, particularly as the US economy appears to have picked up steam in Q2. However, in our view the neutral rate of interest has fallen materially, both in the US and around the world. Perhaps the most convincing reason for this view is that after eight years of recovery and sharp falls in unemployment in the US, Europe and Japan, core inflation is unchanged in the last three years. The Fed recognises this, with many of its members pointing to an academic paper by Williams and Laubach that estimates the real neutral rate of interest to be between 0.5%-1.0%. Thus, with a rate hike in December 2017, and three or four next year, the Fed will have reached the neutral rate.
China’s President continues to stress that the government must contain financial risks and implement bolder economic reforms. With growth set to comfortably meet the 6.5% target for this year, we expect authorities to put more emphasis on addressing economic imbalances and deepening reforms. Of course, the government has already made significant progress on supply-side reform. 65m tonnes of steel production capacity was shut down last year, with a further 50m targeted for 2017. Consolidation has been even more dramatic in the coal industry. In northern China, the biggest four companies now control 70% of production, compared to only 50% as recently as 2015. Further good news comes in the form of an improving consumption trend as retail sales rose 11% YoY in June.
One of the key positive developments in India is that the government is finally addressing the asset-quality problems in the banking sector, which it inherited from the previous administration. It recently amended the Banking Regulation Act to empower the Reserve Bank of India to intervene in specific cases of default, as well as to give the central bank the authority to require specific defaults to be sent to the insolvency court if lenders and borrowers cannot reach a resolution. The other aim of this amendment is to remove a concern shared by all Indian bankers that, if they agree to a haircut on a specific loan, they will be at risk of future investigation by the judiciary. After all, if a haircut is agreed on a loan extended by a state-owned bank, it amounts to a loss for the taxpayer. The banks’ reluctance to take haircuts has been the key cause of India’s long festering bad loan problem, but the RBI’s seal of approval should ease bankers’ concerns. This is important as asset quality problems in the banking sector are the main reason why India is yet to see a renewed private sector driven investment cycle.
We believe that Emerging Markets will continue to enjoy relative outperformance in both the short and long term for a number of reasons. Firstly, Emerging Markets offer superior growth prospects versus their Developed Market counterparts. Indeed, over the past 7 years Emerging Markets have contributed 63% to overall global economic growth. They have also delivered US dollar EPS growth of 9.3% per annum over the past 3 decades, almost double the 5.6% generated in Developed Markets. This ability to deliver structurally superior profitability is due in no small part to their heavily discounted unit labour costs. Even today, manufacturing unit labour costs in US dollar terms are about half those of the US and Germany in neighbouring Mexico and Poland.
Secondly, the region exhibits superior demographic and urbanisation dynamics. According to the UN, 97% of population growth between 2015 and 2050 will take place in developing economies, adding a further 2.3 billion potential consumers and workers versus just 83 million in developed nations. Thirdly, there is significant potential for further structural gains in productivity. Over the past 25 years, economic output per worker has increased 7.5-fold in China, by three times in India and has almost doubled in Indonesia and Turkey. Yet it has considerable room for improvement – India is operating at just 16% of the level of high-income nations, Indonesia at 23%, China at 24%, Brazil at 33%, Russia at 53%, and Turkey at 64%. Fourth, for the private sector in the majority of Emerging Markets there remains considerable scope for credit growth as those countries with underpenetrated credit relative to the size of their economies converge towards the global average.
Fifth, there are ongoing improvements to the governance and regulatory framework in Emerging Markets. For example, a number of countries have made substantial progress in the World Bank ease of doing business rankings since 2009. Russia has moved up by 78 places to within six places of Japan, Taiwan has advanced by 50 places, Poland has risen 48 places, and the Philippines has climbed 42 places. Improvements in governance, regulation and market efficiency should allow for further compression in the cost of equity across Emerging Markets. Sixth, Emerging Markets have learned from previous currency crises and now broadly exhibit relatively robust current account and public sector debt dynamics. Finally, Emerging Markets remain attractively valued versus their Developed Market counterparts, both in terms of equities and currencies, providing scope for long-term revaluation.
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