What’s wrong with Emerging Markets? It’s the Growth, Stupid!!

Ever wondered why equities in emerging markets haven’t been doing well? What suddenly happened to  emerging markets in the last six months that it looks one of the weakest asset classes globally? Why is being there such large amount of capital outflow from emerging markets in 2015? Why are experts even calling for getting rid of the term “emerging markets”?

It’s the growth stupid!

We all Fall Down!!

After peaking in 2010 post the 2008-09 global financial crisis, GDP growth in emerging markets has decelerated continuously. GDP growth in emerging markets is now at a six year low falling from 7.5% in 2010 to 4% in 2015. What is more worrying is the difference in GDP growth between emerging markets and developed markets is now at a 15-year low. With risk premiums higher in emerging markets compared to developed markets and with growth slowing down so significantly and that too for a sustained period of time, one doesn’t need to be a rocket scientist to pull money out of emerging markets.

Investors, especially equity investors look for growth in lesser developed economies. We can see from chart 2 how well GDP growth and emerging markets equity returns are correlated. From 2001 to 2007 this correlation holds even better. GDP growth in emerging markets rose every year from 3.8% in 2001 to 8.7% in 2007.

During the same period the Morgan Stanley Capital International (MSCI) emerging market equity index rose from 317 to 1250, giving a staggering return of 300%. But when the same investors see growth slowing, they do not hesitate to pull their money out. GDP growth in emerging markets has decelerated from 7.5% in 2010 to just 4% in 2015. In the same period MSCI EM index has fallen by over 35%.

Till December 15th, year to date in 2015 the MSCI EM index has fallen by 20%. In fact, from its peak this year at the end of April 2015, MSCI EM index is down by a massive 28%. If we look at the major emerging market economies, the picture is no different. In the same period in dollar terms the Hang Seng China equity index is down 22%, Indian Nifty is down 12%, Jakarta Composite is down 25%, Brazilian Index is down 39%, Russia is down 4%, Thailand is down is 22%, Korea is down 7%, Taiwan is down 16%, Turkey is down 37% and the list goes on.

Not surprisingly similar story exists for GDP numbers as we can see from chart 3. Compared to the period of 2010-2014 GDP growth in 2015 is down in all major emerging markets. It is down by 1.7 percentage points in China, 6.5 percentage points in Russia, 7.8 percentage points in Brazil, 5.5 percentage points in Taiwan, 1.2 percentage points in South Africa and the list goes on.

No Easy Way Out

Now that we have understood why growth is so important for emerging market equities, we need to analyze how this growth can be revived. What could be the drivers of growth going forward in emerging markets? Will private consumption drive growth or corporate spending help in growth revival or may be exports to developed markets help in attaining higher growth?

Let’s start with private consumption first. With the fall in oil prices and weak demand, inflation in most emerging markets is at historic lows. Low inflation with weak economic growth demands policy rate cuts from the central banks. However, most central banks in emerging markets have not been able to cut policy rates at the pace they would have wanted due to expectations of rate hikes in the United States.

An emerging market economy cutting rates at a fast pace with the US hiking would lead to capital outflows from that economy, leading to the depreciation of its currency and in turn importing inflation. As a result of emerging market central banks not being able to cut rates and inflation staying low, the real policy rates, which is the difference between policy rates and inflation is positive in almost all emerging economies. High real rates kill the incentive to spend and increase the incentive to save.

With higher real policy rates the consumer thinks that she is getting a higher real return for every unit of money saved and hence defers consumption. Moreover, household debt in many emerging markets is now much higher compared to a few years back. Fresh borrowing for spending in this low growth scenario looks unlikely. The real policy rates will continue to stay high going forward, not creating enough incentive for emerging market consumers to reduce savings and in turn increase spending.

Will the corporate world of the emerging world help boost growth? The answers are no. Debt levels in emerging markets, especially the private sector debt has risen substantially post the global financial crisis of 2008-09. The large and richer emerging economies have debt to GDP ratios in excess of 200% of GDP. These are staggering levels of debt, comparable to or if not more than the developed economies.

Corporate sector, especially in countries like China, Korea, Thailand and India are heavily leveraged. Many corporations in the emerging world are facing high debt servicing ratio, which has affected the quality of their balance sheets. As a result the banking sector is facing higher NPLs. Lower growth in emerging markets is not helping the banking sector either.

Even in a situation where central banks are able to cut rates in 2016 at a faster pace compared to what is expected, these corporates will keep focusing on paying their past debts at a lower cost and clean up their balance sheets. We will not see high levels of new lending by corporates to expand their production activities or hire new people.

Now let’s see if exports from emerging markets can drive growth like it did in early 90’s or from 2003to 2008. It again looks very unlikely to me. As I highlighted earlier that emerging market growth is at multi-year lows. China is growing through a major slowdown. Europe has kept struggling for many years now. Japan is going through a recession. Lead indicators from US point to a mild growth going forward. These have been the reasons why we see emerging market trade volume growth at lows last seen during the global financial crisis of 2008-09. With the global growth scenario looking weak, I do not see any upside to emerging markets, export growth, both within emerging markets or outside emerging markets.

Is there any way out for Emerging Markets?

Yes, there is!!  Fed rate hike in my view is primarily due to two reasons: improving job data and market pressure. Job data, however, always lags economic activity, with a lag of one or two quarters. Recent job data in US has been excellent because of the economy doing well in the first three quarters of 2015. However, recent lead indicators for US have weakened significantly. ISM manufacturing (equivalent of PMI) fell to 48.6 in November below the critical mark of 50 for the first time in over six years.

The production index and the new orders index both fell significantly to below 50 suggesting a contraction in activities. The growth is Conference Board US Leading Index (comprising of 10 different economic indicators) has fallen to a two year low. Also, the inflation component of the Taylor Rule, which Fed uses as a guideline to set policy rates, is at 1.3%, well below the mandate of 2%. In a situation where Fed does not hike in 2016, we will see the outflow of capital from emerging markets stop. Currencies in emerging markets will stabilize.

Central banks will have more room to cut rates. Private consumption could rise with lower rates and governments could boost spending with more capital available within emerging markets. Growth will arise as a result of these factors combined. So let’s hope that the experts go wrong and the consensus expectation of ~100 bps rate hike by Fed in 2016 does not materialize.