Our forecast that emerging market (EM) GDP growth will comfortably outpace that seen in developed markets (DM) should be good news for investors. However, faster growth will be driven in large part by a pick-up in China after Covid-19 restrictions were lifted, while many other major EMs face downside risks to growth in the months ahead. That will have important implications for asset allocation.
A feature of our latest forecast is that we expect EM economic growth to significantly outpace that of developed markets this year and to remain relatively fast in 2024. We expect EM growth to be about four percentage points faster than DM growth. And, if anything, the recent wobble in the developed market banking sector, which threatens to tighten credit conditions, could lead to even more EM outperformance.
Faster growth ought to present opportunities for investors. After all, relatively fast growth has in the past supported the outperformance of EM assets such as equities, where valuations are also optically less stretched than in developed markets.
However, while we upgraded our forecast for EM GDP growth in 2023, almost all the increase came from China. We expect China’s economy to fare better than expected this year following the removal of the government’s zero Covid policy, and forecast GDP growth of around 6.2%. The reopening of China’s economy, and subsequent services-driven recovery, is likely to support local equities, while the resumption of international travel will benefit some small Asian economies that rely on Chinese tourists. Beyond that, though, we think the spillovers to the rest of the world are likely to be limited. Indeed, we are more concerned about downside surprises to growth in many other EMs.
One reason is that export-orientated EMs are likely to face soft external demand for longer. While it is easy to jump to the conclusion that a pick-up in Chinese growth will drive a recovery in global manufacturing, the bigger picture is that China is not a huge source of final demand for EM exporters. Instead, most final demand still comes from DMs, which has weakened as consumers have pivoted back to spending on services after very strong purchases of goods during the pandemic. And we doubt demand is about to rebound strongly as aggressive interest rate hikes and high inflation increasingly weigh on demand and threaten to tip key economies such as the US into recession.
Some indicators such as the global manufacturing PMI have shown some recent improvement. However, this may prove premature. After all, there are also signs that firms in the goods sector are being forced to hold more inventory as demand falls short of expectations. And other indicators such as global real M1 suggest that the global manufacturing cycle will not find an inflexion point until mid-year. This suggests that expectations of a more immediate export recovery in some EM markets such as Korea could be disappointed.
Elsewhere, downside risks to EM growth come from the lagged impact of aggressive interest rate hikes. If interest rate hikes in developed markets, notably by the Federal Reserve (Fed) in the US, appear aggressive, they pale into insignificance when compared to some major EMs.
For example, policy rates have risen by more than 1000 basis points (bps) from their pandemic lows in Brazil, Chile, Colombia and Hungary. Meanwhile other EMs have tightened by 400bps on average in a bid to keep pace with rampant inflation. It has been well-debated over the past year that interest rate hikes impact economic activity with long and variable lags in EM. However, in broad terms, changes in EM interest rates take six to nine months to feed through to activity and point to a severe hit to growth in the first half of 2023.
Such growth concerns only add to the list of reasons why parts of EM fixed income appear attractive. On a forward-looking basis, with inflation set to trend lower during the course of this year, the return of growth concerns would make it hard for central banks to justify maintaining high interest rates.
For example, in parts of Latin America, markets price real policy rates in the region of 4-6%. These markets already offer good carry, with the potential for bonds to rally as policymakers pivot towards rate cuts perhaps later this year. Latin American central banks are likely to cut rates as growth slows.
Delivering interest rate cuts would also start to brighten the outlook for EM growth in 2024. That could see the rest of the emerging world pick up the growth baton next year, as the recovery in China starts to lose some steam.
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