In our 2015 outlook, further divergence in emerging market growth is a major theme. We believe that the existing divergence in the pace of GDP growth across EM markets and regions is likely to widen for three main reasons: continuing downward pressure on commodity prices; divergent monetary policy impacts; and differing degrees of success from structural reforms in each economy.
COMMODITY PRICES: SWEET AND SOUR
One of the principal factors explaining this diverging economic performance in emerging market growth is the fall in commodity prices. This continues to provide a sweet spot for commodity importers, particularly in Asia’s emerging economies:
• Most visible is the implicit stimulus from lower commodity prices, which reduces production input costs and improves consumers’ disposable income. As a rule of thumb, a USD 10 decline in oil prices is thought to lead to a 0.5% GDP transfer from exporter to importer economies globally. Within this overall figure, richer nations (e.g. Singapore, South Korea and Taiwan) tend to benefit disproportionally from lower energy costs.
• Lower commodity prices also tend to ease inflationary pressures, giving central banks more space to accommodate economic growth. Additionally higher real interest rates raise a country’s relative attractiveness to investors. This effect is most pronounced for lower income countries (e.g. ASEAN and India) where food and energy products represent a large part of the consumption basket. This effect, however, vanishes for larger producers as many operate commodity subsidy programmes which limit the knock-on effect on inflation.
Large commodity importers (e.g. Turkey) should continue to see their balance of payments improve. In contrast, countries/regions whose economies are commodity export-biased will likely continue to suffer revenue erosion and worsening fiscal positions, making it more difficult for them to sustain their populist policies (e.g. Latin America, Russia and the Middle East).
The commodity price theme will likely accompany emerging markets for most of 2015 as market forces push oil and some base metals to trade at prices below their cost curve to ration supply:
• The global energy cost curve shows that the next marginal oil producer is the US (shale oil). To ration existing supply it is thought that WTI needs to trade below USD 65 for an extended period.
• We anticipate seeing a first supply reaction in H2 2015 (in the absence of OPEC actions) given the relatively short half-life of tight oil plays (so-called fracking). However, the existing hedging programmes and strong balance sheets of US oil producers are likely to lengthen the adjustment process.
MONETARY POLICY: MORE ROOM FOR SOME THAN FOR OTHERS
Overall, we see the global monetary policy and liquidity backdrop remaining favourable for risky assets. However, in the context of emerging markets we anticipate a growing divergence in the impact of local and global policy terms favouring emerging Asia and Central Eastern Europe Middle East and Africa (CEEMEA excluding Russia):
• Over the past five years the excess liquidity from developed market central banks has helped to dampen bond yields in emerging markets as the search for yield went global. Overall, global liquidity growth is slowing.
• From a global perspective, we anticipate a diverging monetary policy effect on emerging market regions as the US Federal Reserve and the Bank of England move away from extraordinary monetary policy accommodation. The balance sheet expansion plans of the Bank of Japan and the ECB should create greater excess liquidity for EM Asia and CEEMEA (ex. Russia) compared to Latin America.
• In a local context, the monetary policy environment in Latin America is less supportive for risk assets than that in EM Asia and CEEMEA (ex. Russia). We expect this trend to continue. Firstly, the disinflationary theme gives large commodity importers greater scope to maintain an accommodative monetary policy. Secondly, given current base rates there is a greater capacity to stimulate the economy using normally monetary policy measures in emerging Asia and CEEMEA ex. Russia.
• As China continues its transition to a more balanced economy, the People’s Bank of China is becoming more selectively accommodative to support particular sectors within an economy that is slowing. Brazil, in contrast, has a stubbornly higher inflation rate and more fragile economy, which limits its central bank’s ability to support its economy in a similar way.
STRUCTURAL REFORMS: LEADERS AND LAGGARDS
Finally, it is important to compare the structural reform progress for those countries viewed as having less competitive economies. Understanding the capacity for change and the likely success and pace of reforms is key to understanding emerging markets, which are becoming increasingly heterogeneous. Future productivity and prosperity can be vastly improved in those countries with extensive scope for structural reform.
• EM Asia is already benefiting significantly from the changes implemented over the past year. Structural adjustments are occurring already: China, South Korea, India, Indonesia, Malaysia and Thailand have all undergone positive adjustments in 2014. We expect these reforms to continue. The one exception is Taiwan, which is best-in-class already. Its competiveness ranks in line with Canada, Sweden and the UK.
• Other EM regions are not yet making broad-based adjustments despite the clear need to do so. However, there are exceptions: Mexico and the CE3 countries (Poland, the Czech Republic and Hungary) have made good progress on reforms.
• Question marks remain over Brazil: the country is in need of reform, but insufficient action has been taken so far. The tight 2014 election outcome might have sent a signal to the establishment that reforms are not only required, but also desired. While the potential for reform is significant, the ability for Brazil to enact it quickly is challenging. We believe that investor optimism about the pace and extent of reforms undertaken is likely to be short-lived and to be outweighed in 2015 by the high fiscal and economic pains of adjustment.
CONCLUSION: EM ASIA AND TURKEY FAVOURED
Over the next six to 12 months, based on an expectation of further divergence of emerging market growth, we prefer EM Asia (Taiwan, India, Indonesia and the Philippines) to Latin American equities.
As for CEEMEA, we prefer to remain neutral given the region’s high sensitivity to geopolitical developments. Turkey, however, does look attractive in our opinion as it will find itself in a sweet spot within the region as a commodity importer and beneficiary of any quantitative easing by the ECB as well as re-allocation flows within CEEMEA out of Russia.
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