Quarterly Investment Strategy
Emerging markets: Recovery still in its early innings
A constructive macroeconomic outlook for the US, commodities and China should also help sustain the ongoing recovery in emerging economies, protectionist threats notwithstanding.
Russia has regained policy credibility and stands to benefit from improving oil prospects in the medium term, but vulnerabilities remain in the longer term.
Brazil has probably seen the worst of its down cycle, but unpopular fiscal reforms lying ahead pose risks to the recovery.
Indian prospects are more promising, with pro-growth monetary policies now possible.
Donald Trump’s surprise election, with its promise of protectionist measures, has scared many investors back out of emerging markets. We beg to disagree. Resting judgment solely on US (possible) policies ignores the fact that Chinese developments matter much more to the emerging bloc at large. Not only does Chinese industrial demand directly benefit resource producers such as Brazil, Chile and Russia, but its supply-chains fuel investment and trade across the Pacific Rim – tying together all the economies of the region.
Most emerging countries also stand to benefit from US reflation. Even for Mexico, we would argue that strong US growth with some trade barriers is preferable to continued free trade but a recession just across its border.
Add to that improving fundamentals, with a fading inflationary impact of sharp currency drops since 2014 and relatively low current account imbalances in the BRICs, and we conclude that emerging economies should pursue the stabilization initiated a couple of quarters ago.
As regards China more specifically, sufficient levers are available to continue to lift the short-term growth outlook and avoid a disorderly devaluation: monetary and fiscal policy easing, but also private savings. Admittedly, pulling these levers means backtracking on structural reform efforts, notably in terms of State-owned enterprises, yuan internationalization and excessive credit build-up. At least, real interest rates are now at a more appropriate level, meaning that whatever investment is being undertaken is likely to be of higher quality than in the past. Not everything in China is fine, but the time to be ultra-negative on capital misallocation was in 2011-2012, not today.
In Brazil, the good news is that the vicious inflation / rising interest rates / slowing growth spiral may finally be over. Still, with a budget deficit of near 10%, the interim President’s biggest challenge will be to restore fiscal policy credibility – requiring unpopular reforms of the minimum wage and social security benefits.
Russia meanwhile has regained substantial such credibility, also on the monetary side, which reduces its vulnerability to capital outflows even as the Fed becomes more restrictive. The current account is in surplus, the budget deficit under control and the ruble has been floating freely for two years. That said, overdependence to oil continues to make Russia vulnerable longer term. Unlike some emerging peers, Russia has no “youth dividend” to lift its potential growth rate.
A final word on India where the new central bank Governor is giving pro-growth signals, made possible by the successful battle on inflation fought by his predecessor. The opening of several industries to foreign direct investment is also encouraging, while an enlarging of the tax revenue base, via the new goods and services tax, will be key in achieving budget deficit targets.
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