When thinking about the global economic outlook, investors have a tendency to focus on how late-cycle the U.S. economy is, and the implications for the rest of the world. However, it’s important to note that other parts of the world are either early-cycle (like emerging markets ex-China) or mid-cycle (like the euro area and Japan).
Indeed, the fact that various economies are in different stages of the cycle is one of the key reasons why we expect the global expansion to be stronger for longer. Emerging markets ex-China, in particular, should be a key driver for the growth acceleration that we expect in 2018.
Why are we constructive EM ex-China? Our view centers on four key debates:
1) What is the domestic driver of the EM growth story?
While there is a general perception that strong growth in China and rising commodity prices have driven the EM outlook, we believe that the domestic policy mix is a more critical component.
In this context, the taper tantrum in 2013 and the commodities price drop in 2014-15 were mere triggers of the EM adjustment phase. The underlying reason for the challenging macro environment for EM was the previously poor policy mix (low-to-negative real interest rates, aggressive fiscal expansion and distortion in labor markets).
However, most EMs are now maintaining adequate real interest rate buffers, have been on a path of fiscal consolidation and are not intervening in the labor market, which we believe will ensure that macro-stability indicators remain largely in check.
2) Will EMs be able to withstand higher rates in the U.S.?
We are forecasting a gradual rise in U.S. interest rates (a rise in real policy rates by 50bp by end-2018), considering that the Fed is less likely to be concerned about the risks of an inflation overshoot..
In some ways, this U.S. policy rate hike cycle is similar to the one in the mid-2000s, where the U.S. dollar remained weak and EMs’ growth cycle was not derailed by U.S. monetary tightening. In a similar vein, EM central banks will hike rates in the coming quarters, but this will be in a countercyclical fashion warranted by stronger domestic growth and inflation rather than the pro-cyclical tightening that we had in 2013.
Additionally, stronger growth in developed markets is providing an offset by helping to revive EM exports. Considering our expectation of continued strength in the capex cycle of developed markets, EM exports growth should remain supported, thereby reducing pressure on EM policy-makers to support domestic demand growth with loose fiscal/monetary policy. This is bringing about a significant improvement in the productivity dynamic.
3) Will a rise in protectionism threaten the EM recovery?
On the heels of January’s import tariffs on solar panels and washing machines, the U.S. administration could impose tariffs on aluminum and steel next. While these four products account for only 4.1% of total U.S. imports (0.5% of U.S. GDP), these measures raise concern about a full-blown trade conflict.
In our base case, we think that key trade partners like China, Japan and Korea will be measured in their response. They will likely take retaliatory measures which are less than proportionate—such as filing complaints with the World Trade Organization and launching counter investigations—while being careful to avoid an exacerbation of global trade frictions.
Moreover, we believe that the underlying global end demand conditions will matter more for trade growth, as suggested by Japan’s experience during the 1980s.
4) Will a slowdown in China bring downside risks for other emerging markets?
While we forecast China’s growth to slow by 30bp to 6.5%Y in 2018, the quality of growth should continue to improve as the government takes up efforts to reduce financial stability risks and rebalance the economy.
We believe that China’s efforts to rebalance by way of slowing investment growth are a positive development for the rest of the world. When China was lifting investment post credit crisis, it weighed on returns on capital employed in the rest of the world due to its role as a large market but, more importantly, as a marginal competitor, considering that China accounts for 26% of annual global investment.
However, with steady efforts on supply-side reforms, we are already witnessing a turnaround in capital efficiency in China (and the attendant impact of an exit of producer price deflation). In 2017, China required 3.2 units of new debt for every unit of nominal GDP growth, down from 5.7 in 2016.
Bottom line: The role of emerging markets ex-China in driving the global cycle should not be underestimated.
In purchasing power parity-weighted terms, EMXC now accounts for 41% of global GDP (24% in USD terms), more than twice the size of China (18% of global GDP; 15% in USD terms) and interestingly similar to DMs at 41%. Hence, as the recovery in EMXC gathers further momentum, it will be a key driver of the global growth acceleration, contributing 41% to global growth in 2018 and 43% in 2019, up from 36% last year.
Adapted from a recent edition of Morgan Stanley Research’s “Sunday Start” (February 25, 2018) series. Ask your Morgan Stanley representative or Financial Advisor for the latest market strategy coverage and reports. Plus, more Ideas.
