Peter Szopo of Erste Asset Management -
The drivers of economic growth in emerging markets (EM) and the turnaround in global real interest rates are the key themes featured in the latest edition of the IMF's World Economic Outlook from early April. It should be obligatory reading for investors, particularly for those with EM exposure. The report implies that US and Chinese growth risks and the trajectory of global real interest rates are the key developments to be watched by EM investors. While this does not look like an overly revolutionary insight, the value-added of the Fund’s research are the figures that come together with the narrative. Among other things, they shed some light on how global shocks (in an econometric sense) will affect Russia, Turkey and Poland – the three largest economies in Emerging Europe.
Five results are worth highlighting, in my view:
1) The Fund forecasts that the growth gap between EM and DM continues narrowing in 2014 to 2.7% - the lowest figure since 2001 -but will expand to 3% in 2015. Slower EM growth has been among the main reasons for the underperformance of EM equities relative to DM over the past three years. Thus, any signs that the EM/DM growth convergence is turning will likely support EM stock markets. The fact that EM indices slightly outperformed their DM peers year-to-date (EM +0.9%, DM –0.9%, up to Apr 14, 2014) despite the threats emanating from the US Federal Reserve about it "tapering" its bond-buying programme, geopolitical tensions and a fragile political backdrop in a number of emerging economies could be a sign that the relative retreat of EM equities is ending. The relatively benign valuation of EM equities, which are trading at an approximately 30% discount to DM equities (both price/earnings and price/book) provides support as well.
2) Global real interest rates, which have been trending lower for more than three decades, will likely start rising. However, the pace of the ascent will be pedestrian, due to the lasting impact of the financial crisis and a secular portfolio shift in favour of bonds. From this angle, the market’s reaction to the Fed's tapering announcement last May, which triggered another down leg in the relative performance of EM equities, was overdone. In fact, the US yield curve has shifted lower since the Fed actually started tapering and the semi-hawkish noise emanating from the March FOMC meeting had only a temporary impact. According to the Fund, “there are no compelling reasons to believe that rates will return to the levels of the early 2000”, which by way of implication suggests that the US 10-year treasury yield is not expected to exceed, say, 3.5% until 2018.
3) A positive US growth surprise is a key catalyst for EM growth, even if accompanied by higher US rates. The Fund estimates that a 1-percentage-point (pp) increase in US growth is lifting EM growth by 0.3pp. Somewhat surprisingly – and probably causing some discontent for the current administration - Russia is among the prime beneficiaries, gaining almost 0.8pp on impact from faster US growth, and more than 6pp cumulated over two years. Turkey and Poland, the other large economies in Emerging Europe, naturally benefit as well, but to a much lesser degree (2.5pp and 1.3pp respectively over two years).
4) Tightening external financing conditions for EM due to a rise in risk premiums reduces GDP growth. The IMF estimates that a 100-basis-point increase in the EMBI yield lowers EM economic growth by ¼pp on impact with negative effects lasting for more than two years. Within the Emerging Europe space, Turkish growth is hit much harder (by almost 1pp) than Russian and Polish growth in the short run. This is to be expected given Turkey’s higher government and external debt, as well as its notoriously negative current account. In the case of Turkey, however, the negative impact seems to quickly evaporate, because after two years the cumulative impact is positive, in contrast to Poland and Russia. The IMF does not provide an explanation for this surprising result, but one obvious reason could be the higher flexibility of the lira in comparison to the zloty and the ruble.
5) As one would expect, the health of China's economy is another important driver for EM growth. A 1pp increase in China’s growth (not induced by higher US growth) will raise EM growth by 0.1pp on impact and by 1.5pp cumulated over two years. The impact on the big three economies in emerging Europe varies significantly: faster Chinese growth raises Russia’s growth in the short run and cumulated over two years (0.3pp and 2.9pp), while both Turkish and Polish growth is affected negatively (!) on impact. One of the key transmission channels of faster Chinese growth to the global economy is the upward pressure on commodity prices, which clearly supports the Russian economy, while hurting a commodity importer such as Turkey.
Thus, from a top-down view, the implications for Emerging Europe equity investors seem straightforward: In case US and China growth surprise on the upside and EMBI spreads stay elevated, Russia is poised to outperform (assuming the Ukraine situation is not deteriorating), while Turkey looks less attractive, with Polish equities moving somewhere in between. If growth in the two largest economies worldwide falls short of expectations, and EMBI yields soften, Turkey is set to outperform, while Russian stocks will likely disappoint.
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