Quarterly Investment Strategy
EMERGING MARKETS: AN UNEXPECTED PERIOD OF PEACE
In a nutshell:
- There might be light at the end of the tunnel for emerging markets, thanks to the stabilisation in commodity prices and the US dollar.
- Even in the worst-hit regions – Latin America and Russia – there are hints of more constructive, if still tenuous, policy changes.
- Contrary to widespread fears at the onset of the year, 2016 should not see a collapse in the renminbi.
Their relentless sell-off has brought emerging assets and currencies to levels better aligned with a realistic assessment of their economic perspectives: investors no longer expect rapid growth to resume in the foreseeable future. This is not to say that emerging economies will not recover as 2016 progresses, the combination of more anchored oil prices and US dollar being just what they needed for a turnaround.
Given that Latin America and Russia have suffered the most acute recessions – and associated fears of default – it is only natural that their market bounce backs have been the strongest during the relief rally that began in February. In Latin America, smaller countries outside the crisis trio of Brazil, Argentina and Venezuela have actually held their ground in terms of macroeconomic stability, and are now benefitting from the newfound calm provided by commodity and currency markets. Even within the aforementioned trio, although the situation remains critical, the domestic economic outlook may at last be stabilising and there are hints of more constructive, if still tenuous, policy changes in Brasilia and Buenos Aires. In Russia, meanwhile, a near 8% decline in domestic inflation, driven mostly by prevailing recessionary conditions, has allowed the central bank to cut interest rates to more supportive levels without worrying about the impact on the ruble, currently supported by oil price stability.
This unexpected period of peace could easily be disrupted by macroeconomic or financial turmoil in China, although recent data buttresses our hope that such an outcome is unlikely. China’s structural slowdown – or rather, return to more conventional growth path similar to that of other emerging markets – was brought to full attention last summer in the wake of its stock market debacle and unexpected currency policy innovation. While this challenging structural outlook is here to stay, recent economic data releases do point to some stabilization of the domestic business cycle and capital flows. Admittedly, this stabilization has been facilitated by a rapid pick-up in Chinese onshore credit, which could exacerbate the country’s medium-term financial risks. Still, it is important to note that this debt build-up has been accompanied by external corporate deleveraging, meaning that the overall debt burden has not grown to the same extent. We would also argue that China has deliberately chosen to lever up domestically as a means of fighting cyclical pressures, rather than taking the path of currency devaluation. By sustaining consumers at the expense of overly dominant heavy industries, a stable or even strengthening renminbi keeps the reform pressure on the economy.
China’s delicate balance between cyclical support and structural reform
This year’s National People’s Congress confirmed a pro-growth bias in policy, targeting 6.5-7.0% GDP growth, 13% growth in the near-money (M2) supply and a fiscal deficit amounting to 3% of GDP. Perhaps not to lose the long-term picture entirely, the meeting also provided some detail on the restructuring of industrial sectors saddled with excess capacity, notably steel which has been at the heart of the air pollution and industrial policy debate in China.
Other details of so-called “supply-side” reform were still hazy – and consistent with the pro-growth bias. While the government has made noises about using fiscal resources to support industrial restructuring, the National Development and Reform Commission denied trying to engineer another wave of mass layoffs from State Owned Enterprises (SOEs), such as that implemented by Zhu Rongji in the late 1990s. Further, the encouragement to write off non-performing debt has yielded an odd scheme for loan to equity conversion, and efforts to change the governance structure of SOEs centre on mixed ownership plans and mergers and acquisitions between central SOEs. These measures could indeed create some churn in the industrial sector, but will not lead to a sudden material change in the credit allocation within the Chinese economy. Reform will be a lengthy process.
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