Collapsing terms of trade from the commodity slump, a liquidity squeeze from the USD rally and a rapidly weakening credit cycle amid stagnant productivity growth isn’t the macro backdrop for EM outperformance. Emerging market equities as measured in the MSCI index have underperformed developed markets by another 6 percentage points so far in 2015 while the price/book ratio on the MSCI EM has fallen to about 1.4x versus 2.2x for the MSCI World, a discount of over 30%. Emerging market equities reached a price/book premium to the MSCI World of 18% in 2010, amid consensus ‘10% China growth forever’ euphoria as the country fuelled the post-crisis commodity rebound with an historic credit/construction boom, now unwinding.
A point we’ve long made is that the biggest losers from China’s trend growth slowdown/falling resource intensity of growth would be outside the country, among the countries pulled along on its credit/investment stimulus coattails pre 2012. While GDP, retail sales, investment and credit growth are all clearly slowing across GEM, an added problem is deteriorating data quality at a critical time for policy credibility. For instance, India bulls often say that for all its faults, at least unlike China the country has data you can trust and independent institutions like the RBI. That’s become a highly questionable assertion.
While the country’s GDP calculation certainly needed modernizing, political pressure drove changes to the methodology which have made the new data hugely flattering and at odds with other metrics from listed corporate revenues to credit growth. It’s a far guess that manufacturing added value is about double what it should be and non-financial saving about 2.5x higher, if the calculations were based on internationally accepted conventions and the recommendations of the CSO’s own subcommittee. On the official data, EM growth is now only three percentage points higher than developed world, but given that China’s growth is likely overstated by 1.5-2% and India’s by 1-1.5%, the differential is even narrower.
Our view since 2013 has been to structurally underweight commodity FX terms of trade losers from Indonesia to Malaysia and Brazil (and note that amid the wider EM FX carnage, the Indonesian Rupiah is now at a post Asian crisis low, as while Indonesian consumer credit growth has fallen sub 10% y/y). China’s shift to a services led growth model since 2013 (albeit flattered by the booming stockbroking sector in recent quarters) was predictable but still stunning in its speed; manufacturing and real estate investment growth running at over 30% and 27% y/y at end 2011 is down to sub 10% and sub 5% respectively as at June.
Import volumes into EM countries ex China are now negative, investment growth is heading that way and with persistent currency weakness pressuring inflation higher as the Fed prepares to finally raise rates, many EM economies will have to raise rates to curtail capital outflows. The net equity earnings revisions ratio (and return on equity) is still deteriorating just about everywhere, but especially for commodity exporters like Malaysia and Indonesia and the Eurozone and Japan still look relatively better value.
If emerging economies continue to deteriorate in H2 as seems likely, the impact will be felt globally as their huge FX reserve accumulation since the late 1990s continues to reverse (undermining the oft quoted ‘liquidity glut’ theory for low US rates) while multinationals with large EM consumer exposure will see earnings and revenue forecasts pressured far beyond the luxury market e.g. motorbike sales are slumping in Indonesia. While the modest recovery in Europe and Japan looks sustainable, a full blown EM crisis would be a global deflationary shock, particularly if associated with an RMB devaluation. The PBoC is now fighting deleveraging risks/propping up asset collateral values on so many fronts, from the ever growing local government debt swap to the attempt to stabilise collapsing A-shares, that something will have to give…