The increase in volatility in global financial markets over the past several weeks has raised concerns that the rally in emerging markets equities may come to an end. The market uncertainty is caused by the conflicting stances of U.S. monetary and fiscal policy; while the Federal Reserve is intent on tightening monetary policy, the Republican Administration has embarked on massive fiscal expansion. The fear is that fiscal pump-priming in an economy near full-capacity will boost inflation and compel the Fed to accelerate interest rate hikes, which could impact demand for riskier asset classes such as EM equities.
There is no question that the fiscal expansion being engineered by Washington is unusual policy this late in the business cycle. The current U.S. economic expansion, now in its ninth year, looks mature, given low unemployment and scarce idle capacity in the economy. The Republicans hope to trigger a sustainable boost in U.S. GDP growth, to 3% or above. However, given expected labor force expansion of 0.5% and recent annual productivity growth of 1%, any growth above 2% will be ephemeral. Unless higher growth does materialize, the policy is expected to engender huge fiscal deficits in the years to come. This will happen at a time when private savings have collapsed to record low levels. This means that fiscal deficits will have to be financed by foreign savings, resulting from higher trade and current account deficits. U.S. personal savings and expected fiscal deficits are shown below.
In the past, rising current account deficits in the U.S. have been favorable for emerging market asset prices. Large U.S. deficits signify a strong, late-cycle U.S. economy. This is typically accompanied by a weakening dollar and increased global liquidity, which is very beneficial for emerging markets. The last time we saw this was between 2003-2008 when twin deficits in the U.S. led to a weak dollar and booming asset prices in emerging markets. The reason that this happens is the following: 1. The overheated U.S. economy results in large current account deficits; 2. Surpluses accumulate in foreign central banks which intervene in currency markets to avoid accelerated appreciation; 3. These surpluses are very difficult to sterilize and stimulate credit and economic activity;4. As investors see currencies and markets appreciate they pile into the markets, causing additional upside pressure on asset prices.
As the U.S. economy strengthened over the past two years and the output gap was closed, this process already started. EM currencies and asset prices had reached very low levels in 2015. Now, after outperforming developed markets for two years, EM equities are no longer dirt cheap, but they are still very inexpensive relative to U.S. equities. We are probably about mid-cycle for EM. Economies are starting to gain some traction and equities are reasonably priced, at about historical averages. If the cycle progresses normally, we should see increasing liquidity push asset prices considerably higher for at least the next twelve months.
In contrast to the U.S., most EM economies are in the early or mid-stages of their business cycles, and the commodity-rich economies are just exiting from the deep slump caused by low commodity prices in recent years. Commodities also benefit from the overheated U.S. economy and the weak dollar, adding fuel to the emerging market cycle. The chart below shows were EM countries lie in the business cycle.
Of course, there are risks to this scenario. What could abort the global liquidity cycle?
- An acceleration in U.S. inflation, triggering more aggressive Fed policy is a possibility. If U.S. inflation where to spike above 3%, the Fed would likely respond aggressively and could provoke a recession.
- Trade Wars. U.S. tariffs and subsequent retaliations, would be inflationary and create uncertainty.
The most benign scenario for emerging markets is for a continuation of the trends of the past several years; this is a “Goldilocks” scenario of disappointing GDP growth and stubbornly low inflation, which allows the Fed to pursue its gradualist, “asset-friendly,” strategy. This is probably the most likely scenario at this time, and it could mean the extension of the business cycle for another year or two, in an environment of ample global liquidity.
Higher volatility in financial markets could also be a positive new element, to the extent that it caps enthusiasm for U.S. equities and allows emerging market equities to attract more flows and continue to outperform.
Fed Watch:
- Dalio on the business cycle (Linkedin)
- There will be no economic boom (Seeking Alpha)
- The U.S. business cycle (Seeking Alpha)
- Gary Shilling on the Fed (Shilling)
- World Finance in peril (Telegraph)
India Watch:
- India is starting to move the oil markets (Oil price)
- India needs to create salaried jobs (Livemint
- RBI warns on Modi’s budget (QZ)
- India’s protectionist budget (Swarajyamag)
- India launches Modicare (Swarajyama)
China Watch:
- China’s shadow banking system (BIS)
- Shandong Ruyi textile group buys Bally luxury shoes (SCMP)
- Cruise ship industry is booming (WSJ)
- China and free trade (NYtimes)
China Technology Watch:
- China is winning the battery war (WSJ)
- China and the AI war (Science Mag)
- Interview with JD.com’s Richard Liu (Youtube)
EM Investor Watch:
- The enlightenment is working (WSJ)
- Costa Rica runs 300 days on renewables (VT)
- Inflation stalks Macri in Argentina (WSJ)
- Why South Africa matters (FT)
- Which emerging market is emerging (Seeking Alpha)
- PDVSA’s workforce is jumping ship (Oil Price)
- Traders warn EM rally is ending (Bloomberg)
- Brazil’s hedge-funds boom again (Bloomberg)
- Reasons for Brazil’s credit dysfunction (AQ)
- Brazil’s PagSeguro IPOs on NYSE (Bloomberg)
Technology Watch:
Investor Watch:
- The decline of buy and hold (Seeking Alpha)
- Munger says bitcoin is noxious poison (FT)
- On the future of active investing (Forbes)