Emerging economies continue to recover. Growth momentum has been positive for more than a year now, and has accelerated in recent weeks. This is largely why the recent nervousness in financial markets over a possible accelerated tightening in monetary policy in the US and Europe has had little impact on emerging markets (EM).
EM bonds saw outflows for the first time this year, but yields hardly increased. At the same time, EM equities continued to attract new capital and the pace of the outperformance over developed markets accelerated.
In emerging markets, growth momentum has been positive since June 2016. Since then, the most relevant cyclical data in the 20 largest emerging markets have been improving. Initially, it was primarily export-related figures that improved. Commodity-exporting countries benefited the most from higher investments in the Chinese housing market and infrastructure.
By the end of 2016, the broad-based global trade recovery was the main driver of EM growth. And since spring, we have seen a clear improvement in domestic demand in almost all of the emerging countries. This is the result of the strengthening of credit growth for the first time in six years, largely due to rising capital inflows.
In emerging markets, growth momentum has been positive since June 2016Stronger credit growth (from 6 per cent in January to 8 per cent now) should help to give the domestic demand recovery legs in the coming quarters. The growth recovery, which is not only stronger, but is also more broad-based with exports, investments and household consumption all contributing, is the main reason for the more favourable risk sentiment towards emerging markets.
This was reflected in the last week of June and the first weeks of July, when bond yields rose in Europe and the US, but it had little impact on bond markets in the emerging world. Given the strong inflow of new capital in EM bond funds over the last two years, and the fact that these products are traditionally sensitive to interest rates in developed markets, this is certainly worth mentioning.
Based on China’s most recent cyclical data, and credit data elsewhere in the emerging world, we may assume that EM growth recovery will continue in the coming months. This means the risk of large outflows from EM funds is likely to remain controllable even if interest rates in the US and Europe continue to rise.
Key points
Growth momentum in emerging markets has been positive for more than a year.
Based on China’s most recent cyclical data, we may assume that the EM growth recovery will continue.
EM bonds should be able to benefit from the improving growth prospects.
Still, in the current environment of strong EM growth momentum, and upward pressure on interest rates in developed markets, EM equities are clearly more attractive than EM bonds, as equities benefit more from accelerating growth and are less sensitive to the narrowing interest rate differential between EM and developed markets (DM).
After years of strong capital inflows, EM bond yields are also well below their historical average, while the valuation discount of EM equities relative to DM equities is close to its highest level since 2008. In 12-months forward PE terms, EM equities are around 30 per cent cheaper than developed markets (see the chart).
However, EM bonds should also be able to benefit from the improving growth prospects. After all, the pick-up in domestic demand growth is positive for fiscal accounts, while the strength in global trade should help to prevent a harmful widening of external deficits. It remains important to stress that despite the better growth picture, inflation in the emerging world is still low, at levels below 3 per cent on average.
The steady capital inflows of the past years have led to a sharp appreciation of exchange rates, so much that, by now, in real effective terms, EM exchange rates have recovered half of the big 2013-2015 decline. The strengthening exchange rates in combination with still-below-potential economic growth rates have kept inflation rates low, and have enabled and continue to enable EM central banks to cut interest rates. The combination of improving growth prospects with declining interest rates is particularly beneficial for local currency debt.
The main risks to all EM asset categories are still a shift in market expectations about the speed of DM monetary policy normalisation, and a sudden flare-up of China financial system concerns. Both risks need to be monitored closely. For now, it looks like both the Federal Reserve and ECB will remain very cautious. Recent growth and inflation data do not suggest that an acceleration in policy tightening is near.
With the euro on a clear strengthening path, the possibility of no moves by the ECB well into next year has even increased. And where China is concerned, the recent growth and capital flow data suggest that the authorities have been successful in regaining the minimum of control over the economy they need to prevent volatility in growth and large swings in investor confidence.
The verdict is still out whether China can reduce its leverage growth and high dependence on credit. And whether the authorities can avoid financial system stress as the pace of economic growth gradually comes down to more sustainable levels remains a big question. But one cannot ignore that the recent policy focus on deleveraging and tightening regulation on the opaque and aggressive risk-seeking shadow banking sector is the right one.
Therefore even in China, the principal cause of the painful 2010-1015 EM correction, change is positive now. This has already explained part of the EM resilience since early 2016, but should continue to sustain investor risk appetite to EM assets for a bit longer.
Maarten-Jan Bakkum is senior emerging markets strategist at NN Investment Partners