Trade 'Normalization' Likely To Hurt Emerging Markets

| About: iShares MSCI (EEM)
This article is now exclusive for PRO subscribers.

Summary

World import growth has remained below-trend since Q2 2011 and the ratio of imports to GDP has flattened after a large rise throughout the 1990s and 2000s.

Contributing factors: lower business investment, increasing dependency ratios throughout the developed world and the diminishing impact of the removal of trade frictions (business entry, tariff reduction, decline in transportation costs).

Compositional effects are also notable influences; the movement of capital to emerging markets has increased life quality and increased wage demands, reducing the value-add of supply chain elongation.

Over the long-run, import growth will not logically exceed the rate of GDP growth.

Consequently, the slowdown in trade activity may represent a pattern of normalization.

Declining globalization represented one key macroeconomic trend in 2016, which, at the same time, coincided with the nationalist political sentiments that helped spur along the Brexit and Trump phenomena. Before the financial crisis in 2008, global trade grew at roughly twice the pace as global GDP. This trade to GDP ratio, commonly deemed the "income elasticity of trade," has since declined to around a one-to-one level in the eight years since. There are several reasons for this occurrence.

1. World import growth has averaged 6-7% since 1970, but has since trended below that growth rate since Q2 2011. While there have been large recession-related dips in import growth, the below-trend growth we are currently witnessing is the longest such streak in the 46-year history represented.

The early-2011 drop in import growth also coincided with a steep decline in the global imports to GDP ratio. This figure increased rapidly from 1995 through 2008, regained its previous momentum coming out of the recession, before flattening in Q1 2011 and remaining that way through the present.

As we can see, the global imports to GDP pattern is broadly similar to the price movement of the most common emerging markets ETF (NYSEARCA:EEM):

EEM Chart

EEM data by YCharts

Given such stark, sudden and enduring change, it's fair to ask whether this is merely a temporary bog or something that represents an underlying structural shift. For example, over time, factors such as declining transportations costs, reduction of trade barriers, and more cost-efficient product inputs have all boosted the income elasticity of trade.

Since the financial crisis, business investment in particular has slowed, which typically has a high import content. In the US alone, real private non-residential fixed investment has grown just 1.03% since Q4 2007, after growing by 3.66% from Q1 1999 to Q4 2007.

(Source: US Bureau of Economic Analysis; modeled by fred.stlouisfed.org)

This, in turn, has represented a strong headwind to trade growth. Theoretically it should be temporary, as businesses should be more inclined to invest once they become more confident about their economic futures.

Moreover, while trade liberalization and technology improvements may have helped amplify the income elasticity of trade ratio earlier, the influence of these elements may be waning and pushing the ratio closer to one-to-one, as might be expected in equilibrium.

Whatever the case, understanding the true nature of external demand for domestic goods is vital to policymakers given the role it has in helping better understand future domestic growth and inflation prospects. On top of this, having the awareness as to how trade ties fit together provides politicians and central bankers with a clearer understanding of how exogenous shocks may impact the domestic economy.

2. There may also be some level of influence owed to compositional effects as wealth, business activity and factors of production are redistributed among countries. Trade from developed economies to emerging markets makes economic sense in the context of the advanced economy lowering its cost of production, while the developing economy benefits from the on-shoring of new business activity and improved labor utilization.

The transfer of growth from developed to emerging markets is likely to result in lower trade elasticities, where lower levels of business investment and rising labor costs can expect to eventually erode the rate at which imports exceed the rate of aggregate growth. Even at the country-level, the decrease in investment will undermine this ratio by reducing productive capacity and further moderating global trade activity.

3. I've explained in prior articles that a logical component of declining international trade activity has to do with the basic demographic element of aging in developed markets. Wealthier economies are predominantly the destination of the final outputs. People's needs tend to decrease as they age, leading to lower consumption per individual over time.

By 2080, the dependency ratio of the European Union - defined as the number of aged 65+ persons (the point at which they typically become economically inactive) per every working-age citizen (age 15-64) - is projected to nearly double, from 28.8 in 2015 to 51.0 in 2060.

4. In prior decades, the assimilation of developing markets into the global economy caused the proliferation of global supply chains. Corporations in developed economies, assuming relatively frictionless entry, could choose the lowest-cost producer for a certain product or specific input to boost margins. However, with the development of these countries, wage demands have subsequently increased, reducing the value-add of taking on the risks associated with elongated supply chains.

In theory, once rising wage costs and the riskiness of complex supply chains are integrated into decision-making, the boost this tactic previously provided to boosting the income elasticity of trade will erode to the point where re-establishing production back in advanced economies may become increasingly observed.

5. The aggressive expansionary monetary policies employed by the central banks of developed economies has led to a substantive increase in financial deepening - generally measured by the ratio of money supply to GDP. For the US (and by extension all other developed nations), financial deepening is at an all-time high:

(Source: Board of Governors of the Federal Reserve System; modeled by fred.stlouisfed.org)

The substantial uptick in liquidity lowers interest rates to stimulate lending demand. However, if the monetary experiment is overdone, the capital will be invested into projects where the goods and outputs produced won't have sufficient demand, leading to overcapacity. Therefore, each additional dollar or stimulus provided by quantitative and credit easing programs will have diminishing returns with respect to its ability to support export activity.

In this instance, there are linkages to other factors mentioned above. For example, lower tariffs and money supply expansion can help firms invest in factories abroad to off-shore production of a particular input or product altogether. Therefore, decomposing the influence of each is difficult.

Conclusion

Despite lower business investment into capital expenditures, which is likely to be temporary, there are genuine structural changes that will very plausibly impede the rate of import growth to global GDP going forward. The elements of an expansion of the money supply and global supply chains, and a reduction in tariffs and transportation costs have diminishing effects. Whatever influence they had in the past is not likely to create additional trade intensity unless advanced upon further.

Moreover, the long-run expectation is that import growth cannot exceed the rate of economic growth long-term. Therefore, the distorted ratio we witnessed in previous decades could be considered an atypical period that mirrored the innovation of liberalized trade policies that tapped into the largely unexplored frontiers of emerging markets. Hence, instead of a "slowdown," the current pace of trade is likely better understood as a "normalization" to its expected equilibrium.

While 2015 brought a series of trade-diminishing influences from emerging market shocks and natural resource related weakness, 2016's more protectionist biases are unlikely to give renewed momentum to globalization. Accordingly, the recent slump observed in trade activity is likely to be widely comparable to the perceptible downtrend seen over the past 5-6 years. Therefore, we might expect for emerging markets, when considered on aggregate, to be a less appealing option going forward than they were during global trade's heyday before the financial crisis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.