Fundamentals JUN 2015 ENG

JUNE 2015 ECONOMIC AND INVESTMENT COMMENTARY

From Poster to Problem Child: What’s in Store for EM?

Fundamentals:

INSIDE:

Market overview:Lower global productivity

Snapshot:US housing – still early cycle

UK forecast: Political impact

In this edition of Fundamentals, Emerging Market Economist Erik Lueth examines the drivers of the

slowdown and assesses whether slower growth is transitory or here to stay.

happening against a recovery in developed markets, something we observed only once before – during the Asian crisis.

DEMAND VERSUS SUPPLY SIDE

One natural starting point is to ask whether the slowdown is demand or supply side driven, the assumption being that the latter has more lasting effects. If the EM slowdown were demand side driven we would expect it to be accompanied by falling inflation and rising current account balances. In the case of a negative supply shock we should observe the opposite.

At LGIM, our emerging market (EM) analysis focuses on 16 of the larger economies. We calculate trend growth in these 16 economies was 3.5% in 2014 (simple average), down from 5% in the 2000s and 4% in the 1990s (figure 1).

The slowdown stands out for a number of reasons. It is synchronized across most emerging markets, but without the sorts of crisis that we’ve seen in the past. It is also longer lasting: synchronized slowdowns usually last one to two years, while this one is in its fifth year. Furthermore, it is

After a decade where emerging markets were seen as the engines of

global growth, emerging markets are currently undergoing a growth

slowdown that has taken most forecasters by surprise. Does this signal a

change in the fortunes of these economies?

02JUNE 2015 ECONOMIC AND INVESTMENT COMMENTARY

The evidence is quite striking. Average inflation for the EM sample jumped from 6.6% in 2010 to 9.8% in 2014. At the same time, the current account turned from a surplus of 0.6% of GDP to a deficit of 1.2% of GDP, before recovering somewhat in 2014 on the back of weaker currencies.

This result is not driven by a few outlying economies. As figure 2 shows, a majority of countries show symptoms of a supply side shock. This holds irrespective of whether inflation or current accounts are used as the yardstick. Another pattern emerges clearly, namely that all countries hit by a negative supply shock can be characterised as commodity exporters.

THE COMMODITY SHOCK

That the drop in commodity prices played a major role in the EM slowdown is borne out by other evidence. Both the surge in EM growth in the run-up to the global financial crisis and the recent growth slowdown coincided with commodity booms and busts, respectively. Also, on average, commodity exporters in our sample experienced sharper slowdowns than countries that are best described as manufacturing exporters.

China has been the key driver of

commodity prices, particularly metals. It accounts for half of the world’s metals consumption and for all of the recent growth in demand. But, as China rebalances away from investment and construction its appetite for commodities has waned. Copper consumption slowed from 33% growth in 2007 to 15% in 2014, while aluminium consumption slowed from 43% growth to 10% over the same period.

Chinese rebalancing is expected to last for many years. Hence, there is little chance that this EM growth driver will spring back to life any time soon.

WHAT ABOUT EUROPE AND THE US?Can all of the recent slowdown be attributed to China and commodity prices? Probably not. The US and Europe slowed alongside China for reasons that

are considered more cyclical, if protracted. Actually, in terms of final global demand, China hardly slowed, as growing size compensated for lower growth rates. Hence, the combined demand slowdown of the four largest economies, the US, Europe, Japan, and China was almost entirely due to the three developed markets (G3).

To gauge the impact of the G3 on the EM growth slowdown, we identified a group of seven countries that have no direct China exposure: Mexico, Turkey, Romania, Poland, Israel, and India. Specifically, the share of their GDP directly exposed to final Chinese demand is below 1% and none of them, with the exception of Mexico, is a commodity exporter (Mexico exports oil whose price fell only recently).

These economies are closely correlated with the G3, e.g. growth picked up while China is still slowing, but even these economies exhibit a secular growth decline that G3 economies fail to explain.

For each of the six economies, we model growth as a function of their key G3 trading partners. Since the first quarter of 2007, there has been a growth

Source: Macrobond, LGIM

Figure 2. Growth - inflation dynamics

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Figure 1. EM growth slowdown

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slowdown of three percentage points, half of which can be explained by weaker G3 growth, while half is due to other, probably more structural factors (figure 3). This is not driven by a few outliers, but holds for each of the six economies.

This means we should not put too much faith in the G3 returning EMs to past growth rates – not even our manufacturing exporters.

GLOBAL FINANCIAL CONDITIONS

To what extent has the EM growth acceleration over the 2000s been driven by loose financial conditions globally? This is an important question, since the easiest monetary stance on record is about to be unwound and this could further worsen the EM growth outlook.

Dollar financing costs for EMs dropped from 18% at the height of the Asian crisis to 6% today. A large part of the decline was due to credit spreads (and possibly improved fundamentals), but the secular decline of US yields also played an important part. EM local currency yields are also strongly correlated with US yields. Even EM policy rates tend to follow US policy rates, as EMs try to shield their export and manufacturing sectors from exchange rate swings.

If low US rates had been instrumental in explaining the

EM growth spurt of the 2000s, we would have expected more financially open economies (where we measure financial openness as the sum of foreign assets and liabilities over GDP) to have done particularly well. This is not what we observe (figure

4). For example, the decade following 2001 saw emerging markets grow 0.66ppt per annum faster than the previous ten years. However, it was financially more closed economies that experienced the largest growth spurt, with growth accelerating by around 1.2ppt per annum, compared to no change for financially more open economies. As with our analysis of demand and supply-side effects, the results are broad based, rather than driven by one or two outliers.

But if higher global interest rates lead to EM debt crises,

we could see a long spell of lower EM growth. Past issues of Fundamentals (most recently October 2013) have dealt with the risk of balance of payments crisis – which looks contained. Here, the focus lies on sovereign debt defaults.

Figure 5 shows how the incidence of defaults and restructurings increased when the US raised rates in the 1980s. Also, sovereign debt crises have become unusually rare in the face of zero US policy rates. This is almost certainly going to change. Will sovereign defaults merely return to normal levels or will EMs fall like dominos?

On the one hand, we don’t expect interest rate hikes similar to the 1980s, but we note that public debt levels are higher than they were in 1980 and 1997. We can assess the combined effect by multiplying US 10-year yields with EM debt levels. Assuming US 10-year yields of 4.5% over the medium term, this measure would return to 2005 levels when defaults ran at just two per year – hardly an EM debt crisis.

CONVERGENCE

Emerging markets had a very good decade following 2000, and that is unlikely to repeat itself


Figure 3. Growth of EMs without China exposure

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Figure 4. Growth differential between following and preceding decade

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in this decade. But EM growth has tended to exceed developed market growth even before 2000. Is that likely to continue or has the catch-up story run its course? After all, EM income levels have risen, populations are aging, and more emerging countries will provide schooling for as long as seen in most developed economies.

One way to answer that question is to forecast the growth contribution of the key factors of production capital, labour, human capital and productivity.

We estimate the relationship between the growth contribution of capital and GDP per capita (relative to the US, the technological frontier) using data for 80 countries over 30 years. We find an inverted U relationship with a peak at 68% of the US level.

In 2014, the average GDP per capita of our 16 emerging economies amounted to 31% of the US level, meaning that the growth contribution of capital is far from peaking. At the current level, capital accumulation contributes about 1.8 percentage points (ppt) to growth.

The contribution of labour is backed out from UN projections of the working age population.

For the EM16, this contribution has fallen since the early 1970, but remains positive until 2040.

Human capital is calculated using years of schooling: the return on one year of schooling is about 7%. Countries’ average years of schooling are projected to increase up to 12.5 years. This marks the level where the US has stabilised and no country has exceeded it. Based on this we see that the growth contribution of human capital remains steady around 0.5ppt until 2025. After that the contribution starts to decline as more and more countries reach the 12.5 years threshold.

The big unknown is total factor productivity. Here we assume a growth contribution of 0.9ppt which the US managed to achieve at the technological frontier over the past 50 years. This is

obviously conservative since many of the countries we look at are still far away from the technological frontier.

This crude measure of potential growth also suggests that part of the EM slowdown is structural, as labour force and human capital growth have been slowing (figure

6). However, the average EM growth rate is projected to stay well above 3% through the middle of this century and therefore exceed developed market growth rates by a healthy margin.

EMERGING MARKETS TO OUTPERFORM…JUST BY LESSOur analysis suggests that much of the EM growth slowdown seems to be driven by structural, more persistent factors. Even for manufacturing exporters, lacklustre US and European growth only explain half of the slowdown and so may be less of a boost on the upturn. On the bright side, global monetary conditions don’t seem to have a discernible impact on growth, limiting the downside impact of US tightening, though the impact on EM financial markets could be more pronounced. Finally, even under less favourable conditions, EM growth should continue to exceed developed market growth.

Source: Macrobond, Reinhard and Rogoff (2011)*

Figure 5. US monetary policy and the frequency of EM sovereign debt crises

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Number of debt crises Fed Funds Rate (%)EM interest costs (% of GDP)


Figure 6. EM potential growth (simple average)

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*C. Reinhard and K. Rogoff, 2011 ‘From Financial Crash to Debt Crisis’ American Economic Review, Vol 101, pp 1676-1706


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Dec 2013 Apr 2014 Aug 2014 Dec 2014 Apr 2015S&P 500 Nikkei 225Eurostoxx 50 FTSE All-ShareMSCI Emerging markets

Productivity or worker output grew at its slowest rate last year since the turn of the millennium. Touted by central bankers and economists as one of the largest influences on living standards across both developed and emerging economies, the lower average productivity was particularly pronounced in mature economies. Whilst softer data continued to dominate financial headlines over the month, with the Bank of England lowering this year’s growth forecast and Chinese data remaining soft, equity markets have proved resilient.

Market overview:

Lower global productivity

Figure 1. Global equity markets

Source: Bloomberg L.P. chart shows price index performance in local currency terms

UK

Decisive conservative victory

US

Dollar dominates

Despite polls predicting a very different result, the Conservative party won the General Election, even managing to gain a small majority and therefore govern without needing to seek support from other parties. As a result, its commitment to hold a referendum on the UK’s position in Europe by 2017 will go ahead uncontested by a coalition partner. The possibility of a ‘Brexit’ is a hotly contested issue and whilst there is a long way to 2017, it’s likely that the economic situation on both sides of the Channel at the time of the referendum will significantly affect the vote. Over the month, equity markets have performed well and government bond yields are higher (moving in the opposite direction to prices), particularly at the long end of the yield curve.

The latest US core inflation report bucked the recent trend in the US by beating expectations. The stronger inflation print triggered further strength in the US dollar as market participants began to price in an increased likelihood that the US Federal Reserve could raise its ‘data-dependant’ rates sooner than recently thought. Fed Chair Yellen commented that although labour markets are not yet at full strength, tightening steps are appropriate at some point this year, which further supported the change in sentiment. Ten-year US treasury yields are currently at 2.20%, representing a significant uptick over the month, while US equity markets have also managed to beat all-time highs over the month.


Figure 2. 10-year government bond yields

Source: Bloomberg L.P.

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FIXED INCOME

Cautiously long

China cut interest rates for a third time in six months in May on softer-than-expected inflation data. It marks further commitment from the People’s Bank of China to support its economy and liberalise its interest rate market. The Mutual Recognition of Funds initiative was also announced this month, which will allow fund managers to sell Hong Kong-registered funds directly to Chinese investors for the first time – further evidence of China’s commitment to open its capital markets. Both the further stimulus and liberated capital markets have had a positive effect on Chinese equities. Elsewhere in emerging markets, the small recovery in commodities, including iron ore, has provided a welcome boost.

Another China rate cut

ASIA PACIFIC/EMEA

Many credit investors are said to be currently positioned as ‘cautiously long’ or tentatively pro-risk, for fear of been caught out in an illiquid market. Trying to find a concrete view on the future direction of government bonds and rates is equally hard to quantify. Various central banks have proved cautious not only in monetary tightening action but in wording around possible tightening. Should the US raise rates as early as June, this will have significant implications across the globe. For now, most developed government bond yields have moved higher over the month, albeit from exceptionally low levels in Europe.

JAPAN

Yen falls

The Japanese yen has weakened against the US dollar significantly, bringing it close to 2007 levels. Most of the weakness is attributed to the divergence in monetary policy taken by the Bank of Japan versus the US Federal Reserve, especially as the Bank of Japan looks very much set to continue with its massive programme of quantitative easing. The weaker yen has provided a small boost to the export-sensitive Japanese stock market with the Nikkei up since our last Fundamentals.

The euro has weakened on renewed fears surrounding Greece. The political wrangle between Greece and Germany looks set to continue: Germany doesn’t want to be seen as responsible for forcing a Greek exit but at the same time, the Greek Interior Minister has openly stated that Greece will not be able to meet its next IMF payment on the 5th June. The difference in government tack is evidenced by each countries bond yields, with the German ten-year bund yield at 0.61% versus 11.39% for similar maturity Greek government bonds. However, even German yields are significantly higher, with ten-year bund yields rising significantly from the 0.08% all-time low seen in late April. European equity markets have however managed to move higher as the weaker euro is seen as making many of the region’s exporters more competitive.

EUROPE

Depreciating euro


Snapshot:

US housing – still early cycle

Six years on from the financial crisis and the US housing market is still in the doldrums with activity at levels typically seen in recession (figure 1). The US housing market made little contribution to growth last year, disappointing the Fed’s forecast and forcing the FOMC to repeatedly say in its statement that the recovery in the housing sector remained slow. One concern is that if housing can’t grow at today’s low interest rates, then it might never recover. But this misses the underlying healing.

Figure 2. US household mortgage debt service ratio


Figure 1. US residential investment


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We see a number of positive developments which should lead to a stronger housing market over the next few quarters. First, while there are still some pockets of distress, pricing on a national basis has now almost recovered to pre-crisis peaks. This is increasingly eliminating the negative equity which has acted as a barrier to prevent households from moving home. Second, it has taken a long time to work through the excess construction of property in the boom years. But now inventories appear lean. With delinquency and foreclosure rates approaching normal levels, shadow inventory is now almost full absorbed. Third, homeownership rates have dropped to relatively low levels. All the sub-prime borrowers are now out of the market. Employment is currently rising by two to three million jobs a year. This is contributing to a rise in household formation. As the rental market tightens, this should help encourage more people into homeownership. Finally, households have significantly reduced their debt levels and with low mortgage rates, debt servicing costs are historically low (figure 2). Credit standards for mortgages have been easing at a faster pace in recent quarters which means households are in position to begin taking on more debt again.

Timing a strengthening is tricky, but there are some tentative signs of an improvement from housing starts, mortgage purchase applications and pending home sales. Given housing is lagging the rest of the economy it might take a couple of economic cycles to fully recover, but at least housing is unlikely to exacerbate the next recession, even if this is caused by attempts from the Fed to normalize interest rates.


Political impactUK forecast:

Source: Bloomberg L.P. and LGIM estimates*Forecasts are for end of Q2 2016

**Forecast for end of 2016

UK economy Price inflation(CPI)

GDP(growth)

10-yeargilt yields

Base rates $/£ £/€

Market participants’ forecasts 2015%

2016%

2015%

2016%

2015%

2016*%

2015%

2016*%

2015 2016* 2015 2016*

High 1.10 2.40 3.00 3.00 2.90 3.10 1.00 1.50 1.63 1.79 0.76 0.81

Low -0.10 0.80 2.10 1.70 1.55 1.50 0.50 0.75 1.39 1.40 0.64 0.59

Median 0.40 1.60 2.50 2.40 2.03 2.39 0.50 1.00 1.49 1.52 0.70 0.71

Last month median 0.40 1.70 2.60 2.40 1.98 2.25 0.50 1.00 1.47 1.51 0.70 0.71

Legal & General Investment Management 0.40 1.50 2.50 2.30 2.25 2.50** 0.50 1.00 n/a n/a n/a n/a

The outcome of the UK General Election was quite clear. Television, newspapers and online media of all political persuasions were of one voice: this was a ‘seismic change’, a ‘break with the past’ or some other hyperbolic statement as the traditional UK system dominated by two parties appeared to have changed.

That was the political reaction. And markets? Apparently couldn’t care less. Take a look at a six-month chart of the FTSE 100, 10-year gilt yield, or even sterling vs the US dollar and see if you can find the election effect. Sterling and the FTSE were a bit stronger initially, but quickly gave this back, while gilt yields were quite clearly more interested in the general sell-off in global government bonds.

This was no surprise to us. Our analysis1 suggested that historically, elections tend not to have a major impact on markets. Uncertainty around the election was based on the lack of clarity around who would be able to build a coalition and what its policies would be. Once the Conservatives won a majority, that uncertainty disappeared, despite the fragmentation of the vote or the success of the SNP and UKIP. Markets were faced with a change only in terms of removal of Liberal Democrat influence from Tory policies. So no material changes.

Obviously the EU referendum is a potential point of uncertainty. The Bank of England’s not-so-secret plan to deal with a UK exit attracted headlines, but arguably it would be a poor excuse for a central bank that didn’t at least look at the possible effects. While early in the process, we note that Cameron is already downplaying the potential gains to be made in negotiations. Furthermore, it shouldn’t be forgotten that once the referendum campaign proper starts, both the Government and most other parties will be backing the ‘stay in’ camp, as will the business sector.

Aside from the EU issue, what can we expect? More of the same in many areas. There are new anti-strike laws planned, which will increase the attractiveness of the UK relative to continental Europe from a business perspective. But the priorities for the government are unchanged from a month ago: keep spending under control and hope that growth will help bring the deficit down and reduce overall debt. The Government has announced a mini-budget for July 8, which will clarify the spending cuts highlighted in the campaign – where it will be interesting to see if it is going to follow through on the ‘tough’ promises on the likes of welfare spending. Beyond that, attention will be more focused on inflation and the interest rate outlook once more.

1Please see Macro Matters: The UK Electoral Eclipse, available via www.lgim.com

The forecasts above are taken from Bloomberg L.P. and represent the views of between 20–40 different market participants (depending on the economic variable). The ‘high’ and ‘low’ figures shown above represent the highest/lowest single forecast from the sample. The median number takes the middle estimate from the entire sample.

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Fundamentals JUN 2015 ENG