Sources of Difficulty, Adjustments by the Market
For perspective on recent conditions, it's worth looking back to the global financial crisis. As developed markets deleveraged after the events of 2007-2008, emerging markets' economic growth slowed materially over a period of several years. In the process, they became increasingly dependent upon domestic demand as a main source of expansion. While manageable at the outset, this increased current account deficits over time, which became a vulnerability, especially after the Federal Reserve's "tapering" announcement in 2013. Given that global growth had been largely fueled by credit, the demand for commodities dropped off meaningfully worldwide. This was compounded as both China and many developed markets shifted their economic focus from manufacturing and production to services. As most suppliers to the services sector are domestic, the market positions of commodity-supplying countries came under pressure. As shown, real effective exchange rates (REER) for these countries have, in fact, shifted dramatically, even to levels below the 2008 crisis. In our view, the change should be more than enough to compensate for terms-of-trade adjustments due to commodity prices.
Real Effective Exchange Rates Have Adjusted to Commodity Pressures
100=March 31, 1980
Source: Bloomberg, data through November 30, 2015. Manufacturing exporters include India, South Korea, Philippines, Thailand, Poland, Czech Republic, Hungary, Turkey, Israel and Mexico.
1Commodity Exporters ex Russia include Brazil, Chile, Colombia, South Africa,Indonesia, Malaysia
Another pressure relates directly to tightening monetary policy in the U.S., which has created a drain on capital accounts in emerging markets, aggravated by domestic challenges in Brazil, Russia and others, as well as the lack of reforms generally. This has contributed to downgrades in the credit ratings of various emerging markets countries and widening of spreads, although some of the widening has been amplified by credit spread expansion in developed markets.
Emerging Markets Spreads Have Widened Sharply
Spreads over Duration-Adjusted U.S. Treasury Yield: Emerging vs. Developed Markets' Investment-Grade Credit
Source: JPMorgan, data through November 30, 2015. Emerging markets represented by the EMBI Global Diversified Investment Grade Index, developed markets represented by the J.P. Morgan U.S. Liquid Index (JULI) excluding emerging markets
Performance Has Contrasted With Headlines
Despite the negative headlines, total returns of emerging markets sovereigns and corporates have generally been positive in 2015 (through mid-December) and ahead of many other fixed-income categories. Local currency bonds have fallen, however, as FX has declined to reflect current fundamentals. Across the asset class, risk premia have increased, while local rates have reached historical highs (excluding 2008) to offset FX risk and account for inflation pressures tied to weaker currencies. Given soft growth and global disinflation, local rates are at high levels in real terms as well.
Emerging Markets Real Yields Have Increased Sharply
Source: J.P. Morgan, Bloomberg, Neuberger Berman calculations, data through November 30, 2015. The dotted line shows expected real yield through May 2016, based on the current nominal yield and the Neuberger Berman inflation forecast for May 2016. Emerging markets yields are calculated as the average GBI EM yield of Brazil, Chile, China, Colombia, Hungary, Indonesia, Malaysia, Mexico, Peru, Poland, South Africa, Thailand, Turkey and the Philippines.
Cyclical Trough, Shifting Focus to Reform
Overall, we believe that a cyclical trough may have been reached in many emerging markets, even as structural issues remain. Overcapacity in production and the need to deleverage - most notably in Asia - are challenging policymakers to introduce economic reform. In our view, their success in addressing these problems could be a factor that distinguishes between market winners and losers in 2016. Notably, China could continue to press ahead with reforming the State-Owned Enterprise sector, which is politically challenging, as opposed to financial reforms, which are supported by consensus. Countries including Mexico, India and Indonesia could continue to benefit from their reform efforts; at the other extreme, most oil-exporting countries appear likely to remain distressed as, in our view, there is little expectation that a meaningful recovery in oil prices is at hand. Recent political changes in Argentina and Venezuela have raised hopes that misguided policies leading to growing imbalances may be reversed, while political developments will also determine whether there could be a meaningful turnaround in Brazil. Chinese GDP growth, which we believe should decelerate in the coming years to 5.5-6.5% (from around 6.8% currently1), is likely to be more important than the U.S. economy to global growth. This makes China's ongoing rotation from an investment/net exports economy to a consumption economy even more crucial. The transition entails major challenges and suggests a weaker backdrop for various commodity economies, while, because of global overcapacity, it is not immediately bringing equivalent benefits to manufacturers. On the other hand, we don't think that China will use devaluation to kick-start its economy, which would come at the expense of growth elsewhere; rather, we anticipate continued alignment with more modest REER appreciation to keep it in line with economic improvements.
Given the interdependence of emerging and developed markets growth, global expansion cannot continue without emerging markets taking part, as the emerging markets' contribution to global growth has historically been around 70%. Even U.S. monetary policy has grown somewhat dependent on global growth. While the Fed creates pressure on core rates to rise, the European Central Bank and Bank of Japan are heading in the opposite direction, which we believe, coupled with soft emerging markets economic conditions, is likely to offset the impact of the U.S. tightening liquidity conditions on emerging markets to some degree.
Will Divergence Subside?
Assuming that, at a minimum, a cyclical recovery in emerging markets is achieved, and that existing conditions for growth in developed markets remain in place, we would expect to see less divergence in economic performance and policies going forward. We are anticipating that oil prices will recover somewhat, with oil supply and demand more aligned later in 2016. Pricing across hard currency, local currency and corporates generally discounts a higher degree of risk, which may favor weightings with an emphasis on sovereigns and local interest rates. Corporate balance sheets remain more sensitive to growth than sovereigns, but the markets have increasingly taken this into account. With fairly prudent balance sheet management and the prospects of at least a partial recovery, we believe these risks are likely to remain contained. Also, given structural strengths in emerging markets characterized by high international reserves, low public sector indebtedness, floating currency regimes and slower scope for outflows (as portfolio adjustments have already largely taken place), we believe the conditions that in the past became sources of vulnerability and led to balance of payment crises are now largely mitigated.
1Source: Neuberger Berman Emerging Markets Debt team, forecast for 2015.
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