East Capital Pro Letter -

The global economy was shaken rather than stirred during the first half of the year. Macro indicators continued to improve, with growth forecasts revised upwards further (see graph below). But a series of issues emerged that have clouded the outlook for the second half of the year, and we may have seen the last upgrade of global output.

The Greek debt crisis developed into a Eurozone-wide crisis, and the Chinese economy, which surprised on the upside in most of the recent years, started to cause global concern related to its potentially overvalued property market and undervalued currency, at the same time as concerns about US consumption spread. This makes the outlook for the world economy very uncertain, which can be illustrated by the fact that economists are concerned about both inflation and deflation at the same time. Another sign of the high level of uncertainty is the compromise solution at the recent G20 meeting in Canada, where some countries (primarily the US) wanted further stimuli and others (primarily the Eurozone) pressed for more consolidation.

Apart from concluding that we are heading towards continued uncertainty, we feel that we will most likely also see increased divergence between countries and regions.

Different paths

Among the major richer countries, the US and Canada will perform best, whereas Japan and especially the Eurozone will recover more slowly. In the emerging world, Asia will continue to grow at full (or even above) potential, whereas most other regions are quickly coming closer to potential. Russia, Turkey and a set of countries in Central Asia and the Caucasus will grow close to potential this year, whereas a number of countries in Central Europe, Southeast Europe and the Baltics continue to underperform. This is expected, as the latter are still in the midst of a budget consolidation that is limiting domestic demand at the same time as exports are suffering from weak Eurozone demand. We may even see some increased tension within the region, as the political will to implement further budget cuts and tax cuts has weakened lately.

The recovery in Russia and Turkey continues to surprise on the upside, though. The Russian economy looks very strong, with rapidly rising foreign exchange reserves (totalling over $460bn at the end of June) and an all-time-low inflation rate of 6%, which could fall further despite the central bank signalling an end to the rate cycle after more than 500 bps of cuts during the past year. Industrial production has been strong lately - up 12.4% on year in May - and PMI numbers rose to 52.6 in June, suggesting continued expansion. Growth will most likely be somewhat higher than the 5% we forecast, especially if the oil price stays around the current level.

Turkey posted the second-highest growth rate in the world in the first quarter (after China), gaining 11.7%, which is partly a result of a low base effect, and growth will likely exceed 6% for the full year. PMI dropped markedly in June, but remains high, at 53.3. Inflation has been unsteady in Turkey during the first half of the year, and rate hikes cannot be ruled out in the near future.

One possible interesting feature during the autumn could be renewed interest in emerging market currencies, which are generally undervalued. The Chinese decision to unpeg the yuan from the dollar will certainly lead to an appreciation, although it is likely to be relatively modest, as it remains a managed float. Other emerging markets may see their currencies revalue more significantly on the back of strong growth and debt fundamentals, as well as rising interest rates. The Russian ruble and Polish zloty, which are significantly undervalued, could rise considerably in the next six to 12 months against the dollar and euro, and the Turkish lira may also appreciate against the dollar, although it is slightly overvalued.

Equity markets globally, as well as regionally in CEE, had a volatile first six months of the year. Markets performed well during the first three and half months, before the negative sentiment and increased risk adversity put downward pressure on the markets from the second half of April. As a result, only a handful of markets in CEE (Baltics, Ukraine and Turkey) were in positive territory after the second quarter, compared to all but a handful (Slovakia, Slovenia, Bulgaria, Serbia and Austria) after the first quarter. But fundamentals are very supportive going into the second half of the year, especially in the largest markets, which may also be supported by appreciating currencies and global equity flows. Uncertainty about the global economy in general and the Euro zone in particular may continue to put pressure on markets in the near future, but sentiment should eventually give way to fundamentals.