Is the Story of Emerging Markets Intact?

Two new important macro developments have surfaced recently, which deserve our attention for their likely impact on financial markets:

  1. The debate on the so-called tapering of the U.S. Federal Reserve’s (Fed) current loose monetary stance
  2. The changing economic outlook in China

We believe that the most important issue for investors is not whether tapering will start sooner rather than later, but what will happen to equity markets when interest rates begin to rise, probably next year.  China’s abrupt change of direction of their economic policy can have profound implications for emerging markets (EM) as well as the global economy in future months.

First, to examine the potential impact of rising interest rates on equity markets in the next 12-18 months, we ran an analysis of the factors driving interest rates up in the U.S. and their effects on the S&P 500 Index. We learned that, in the last forty years, during periods of policy tightening and rising interest rates, inflation and unemployment have explained roughly 70% of the Fed’s tightening moves. Analysis also showed that the Fed has given much more importance to the inflation variable than to unemployment. The remaining 30% can be explained by a variety of factors, among them the banking system’s condition, monetary aggregates, bank reserves, etc. During the last five major tightening cycles, the effect of interest tightening on the U.S. equity market has not been dramatic.

In China, their newly appointed leadership appears more determined to accelerate the reforms to preserve the sustainability of long term growth, even if it means tolerating lower growth rates in the short term.  From this point of view, the aggressive curbs on bank lending by China’s central bank (People’s Bank of China) in June have led to the so-called “SHIBOR crisis” (code name for Shanghai’s interbank rates) and caught markets off guard. This reaction highlights a major risk facing the Chinese economy: how to correct an unbalanced growth fuelled by an excess of credit to the markets. The determination of Chinese leaders to remove this source of imbalance – potentially a credit bubble – is not bad news for China’s long-term outlook and for the overall global stability. However, we do not know how big the impact will be in terms of lower growth. In fact, we believe this will have ramifications for other emerging economies as well as the global economy.

Separating Wheat from Chaff

So the question is: will a better outlook for developed countries be enough to offset a more subdued growth in emerging markets (EM)?  Given the importance of the Chinese economy and of EM for the global economic picture, we believe that the spill-over effects will not be modest, and that we may be entering a phase of lower global growth.

In the short term, the recent massive sell-off of EM equities is translating into more appealing valuations (both in absolute and relative terms), resulting in a possible rebound from the current level. The main issue, though, is whether the slower than expected growth rate in EM is fully reflected in prices.  Otherwise, we could expect further underperformance of EM stocks and bonds.

For more detailed comments on this topic, see Pioneer’s latest Global CIO Letter.

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