A China slowdown, the threat of higher US interest rates, rising leverage, and the end of the commodities supercycle: there are plenty of issues emerging market investors have had to grapple with. But there is another demon, still partially cloaked, that emerging markets are up against: the relationship between global growth and global trade seems to be loosening.
From the late 1980s until the middle of the last decade global trade, on average, grew twice as fast as global output. Since then it has barely kept pace. globalization has not reversed, but it has slowed. Is this just a cyclical aberration, or a more important inflection point?
Certainly, cyclical influences have contributed to slowing trade. The texture of global growth today seems different from the pre-2007 variety. In the US, sectors like heavy machinery, and construction equipment that have led growth do not make large import demands - certainly not on emerging markets, which specialize in electronic products, light manufacturing and commodities. Meanwhile, Europe, a bigger emerging market export destination than the US, has failed to register meaningful growth.
These headwinds will hopefully moderate over time as the US recovery broadens and Europe’s credit multiplier slowly recovers. Unfortunately, that still leaves structural factors that may limit the size and length of any cyclical upturn in trade.
First, institutional support for trade has already evolved to a fairly mature level. globalization, which has ebbed and flowed over the past two centuries, has flowered since the mid-1980s. Sure, tariffs and other barriers can come lower still, but they have already fallen far, and the negotiations are getting tougher. The easy gains for trade, if one can call them that, are behind us.
Second, while current global leadership has been rightly congratulated for avoiding protectionist policies, the post crisis political and regulatory landscape has indirectly restricted trade by denting growth in migration and banking capital flows. globalization, broadly speaking, refers to the free movement of trade, labour, capital and ideas. There can be little doubt that osmosis of ideas continues unabated, but growth in the other three dimensions has slowed, and this can be self-reinforcing.
Third, one must expect that China’s role as an export node in multiple supply chains, and also as an end user of imported goods, will diminish. Since the mid-1990s China’s growth has been driven by two import thirsty segments: real estate and exports. Now, as it aims to rebalance away from investment towards consumption, China’s import propensity is likely to decline.
Finally, given the US’ new competitive advantage in energy, it is not surprising to see tentative evidence of onshoring there. This, along with the birth of new technologies, such as additive manufacturing and robotics, may mean global supply chains shorten.
But why should all this bother emerging market investors? History teaches us that the single most reliable macro variable in forecasting EM earnings is export growth, so it is no coincidence that both have stalled together over the past three years. If the ratio of global trade to global output is indeed flattening, sell side analysts’ perpetual 12-15 per cent earnings growth forecasts will need to sober up.
Emerging market currencies may have to adjust more than forecast by standard purchasing power parity based models too. Currency levels have always been less important for exports than trading partner growth, but especially so now that global growth needs less imports than it once did. Brazil, Turkey and South Africa are cases in point, where even after four years of persistent currency depreciation there is little evidence of export strength.
Weak trade combined with high leverage may also tempt emerging market governments to make up for deficient demand by spending more. They do have fiscal room today, but this slope is a slippery one. It will not take much for emerging market policy makers to risk compromising their considerable fiscal achievements of the past decade and a half.
Sailing without tailwinds, emerging markets will now have to row harder on reform. The urgency to do so has been dulled temporarily by the calming influence of quantitative easing by G10 central banks. Emerging markets have to decide now if they want to be more than a has-been beneficiary of a fading spurt in globalization, or are happy to tread water, and let new demons get the better of them.
Bhanu Baweja is head of cross asset EM strategy at UBS