14 January 2019
Given the data and policy backdrop, it makes sense to remain cautious on Emerging Markets overall, even as solid valuation arguments could allow near-term rallies and EMs could outperform DM assets in some areas. But it is hard to turn outright positive on EM given the worsening growth conditions in China, compounded by Beijing’s remarkably subdued policy response and unwillingness to reform.
Falling exports to China bode ill for tech cycle
EM data has weakened in the past month or so. The EM manufacturing PMI ticked back down to its post-2016 low, barely in expansion territory. Our EM GEAR slumped in Q4 and is now at post-financial crisis lows, matching June 2015. Economic surprise indices took a further leg down.
Korean exports, a trusty bellwether, are also showing concerning signs. In just three months, exports of semiconductors and exports to China have fallen by over 20 per cent. This bodes ill for the tech cycle, and suggests that negative payback after ‘front-loaded’ demand ahead of the previously planned - and then in December, postponed - US tariffs could weigh on global economic data for a while yet.
Chinese data came in particularly weak, with the NBS PMI slumping into contraction at its lowest since Q1 2016. Our China GEAR has plunged 3 per cent in six months, to just 5.1 per cent, with Q4 the weakest quarter post-crisis. The infrastructure investment pick-up seen in the prior couple of months halted as local governments' response to Beijing's urging tailed off. Retail sales were also surprisingly weak, below 6 per cent year-on-year in real terms. Industrial profits plunged to minus 1.8 per cent year-on-year, in negative territory for the first time since 2015. Ominously, manufacturing PPI dropped even more than expected, up just 0.6 per cent on a year ago and negative over the past six months.
One area that remains notably robust is real estate activity, albeit with worrying signs in secondary market transactions and an ongoing collapse in land sales. A property downturn could prove a worrying ‘next shoe to drop’ in 2019.
China’s policy response disappoints
In China, two key signposts for policy - the Central Economic Work Conference (CEWC), and President Xi Jinping’s speech at the 40th Anniversary of China’s opening up and reform - have come and gone. Both were disappointing. This is particularly concerning given that credit data remains very weak, with our preferred credit ‘impulse’ measure the most negative on record.
Sources: Caixin/Markit, CNBS, PBoC; Haver Analytics, Fidelity International. January 2019. Credit ‘impulse’ is the 12-month change in the 12-month moving average of aggregate credit expansion.
The CEWC suggested no major change in policy stance, indicating a continuation of the fine-tuning and prudent monetary policy seen since summer in an attempt to stabilise aggregate demand. After this, China further cut its reserve requirement ratio (RRR) by 1 per cent, partly to replace expiring liquidity measures, with a similar effective size to last year’s cuts.
China also announced a RMB 810 billion quota for special local government bonds for infrastructure projects, with issuance allowed earlier than usual. This will need to be expanded significantly, as it is still dwarfed by last year’s total. Moreover, 2018’s impediments to infrastructure spending - changed government official incentives and tighter central government control - have not disappeared. In all, general fiscal expansion looks set to be small and may be hugely undermined by slumping local government revenue from land sales. Given the muted nature of easing, with no significant changes relative to H2 2018, Chinese growth is likely to remain under pressure.
Just as important, Xi’s speech on December 18 was defensive of his policies and emphasised the Party’s role at the centre of the economy. Domestically, this gives little confidence that Beijing’s stated intention to ‘level the playing field’ between the private and state sectors will be effective, with such inequality in large part responsible for the painful evaporation of credit to private SMEs in 2018. Externally, it further emphasises that genuine concessions to the US regarding implicit and explicit state subsidies, and aggressive industrial policy, are highly unlikely.
More US tariffs likely
The United States Trade Representative’s statement following January’s US-China trade meetings was noticeably short on positive language, or anything concrete on structural issues. Consensus seems to be that the meetings went fine, swinging back to the idea China can buy the US off with promises to import more goods, and that U.S. President Donald Trump will balk at imposing additional tariffs because he doesn’t want to risk affecting US equities or economic growth ahead of the 2020 elections.
That all sounds dangerously like China’s attitude early last year. China’s lack of willingness or incentive to ‘address the structural issues’ the US demands means that more tariffs are still likely at some point. That said, tariffs should not be overstated as a determinant either of Chinese growth or domestic sentiment; their impact is dwarfed by credit conditions, infrastructure, and real estate.
Fed’s pause, weaker dollar are concrete positives for EM
The US Federal Reserve going on pause and significantly softening its rhetoric is a key positive for EMs. It could continue to catalyse a weaker US dollar given its still-expensive fundamental valuation and a forthcoming US growth slowdown, which would bode well both for EM economies and assets. Oil prices re-setting to a lower level is also a major support for many vulnerable EMs. As such, after near-universal EM hiking cycles seen in 2018, there may be space to ease in several EMs later this year. These are concrete positives that should not be ignored.
However, it is hard to turn outright positive on EM assets, against China’s murky backdrop. Global growth continues to slow precariously, with our Fidelity Leading Indicator posting its worst reading in seven years, and risk aversion is heightened. To put it mildly, these are not conditions that tend to lead to EMs thriving.
While we believe that most EM economies have relatively limited vulnerabilities and thus can avoid a recession or ‘crisis’, there are also frustratingly few that have a genuine reform story and exciting growth prospects.
Conditions contrast with 2016
Those who believe current conditions resemble early 2016 when fears were overdone, setting the stage for a large and sustained EM rally, are likely to be disappointed. One parallel is that the Fed has slashed its hiking projections, but unlike in 2016, the US central bank is still shrinking its balance sheet, and the policy rate is already 200 basis points higher.
More importantly, China had embarked on a huge stimulus program in mid-2015, while today its credit impulse arguably remains the most negative on record, and policy measures have been piecemeal. In addition, 2015 brought rate cuts in India, Indonesia, Korea and Russia - not to mention the European Central Bank’s quantitative easing. By contrast, we enter 2019 on the back of near-universal hiking from EM central banks.
If, as in 2016, we see signs such as Chinese PMIs ticking up, or PPI inflation starting to inflect positively, the picture would change. For now, however, the data is still going in the wrong direction.
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