Cyclical, structural, influential

In a yield-starved, low-growth, low inflation world, emerging markets with higher real growth, inflation and the associated underlying economic vigour may offer an attractive proposition for developed market investors.

In the developed markets, growth is perking up, inflation is subdued, and monetary policy is normalising. At the same time, however, trend growth is on the decline. We expect emerging market economies to accelerate with the global recovery, and to generate higher, long-term trend growth. We analyse the causes and consequences of these developments and implications for emerging market bonds.

The world economy is in good shape: according to our Nowcast models, today’s cyclical upswing, low inflation and easy financial conditions are going to last for several quarters – a view increasingly shared by other forecasters (figure 1).

As a result, major central banks are now in a position to gradually normalize policy. Federal Reserve (Fed) forward guidance points to continued hikes and balance sheet reduction, and European Central Bank (ECB) and Bank of England (BoE) guidance to tapering or hikes. China has already tightened monetary and credit policies after strong Q1 growth acceleration. The Bank of Japan (BoJ) stands out as the lone source of continued extreme stimulus.

Slower trend growth and structurally lower inflation...

Looking further ahead, however, we expect lower nominal trend growth than before the crisis in the major developed economies (figure 2). According to our models, the decline will total 1.75 percentage points in the US, 1 percentage point in the Eurozone and 0.75 percentage points in Japan. Thus, the developed market half of nominal global trend growth should be some 1.5 percentage points lower. Emerging market trend growth also looks set to slow, but will likely hold up better than in the developed markets. This adds up to a global nominal trend growth rate, around 1 percentage point lower than before the crisis.

This low nominal growth environment across most developed markets owes to a structural fall in trend real GDP growth as well as low inflation, compared to growth and inflation trends prevailing before the Global Financial Crisis. The UK is an exception, due to a Brexit-led weakening of sterling: tradeables’ prices are rising, but headline inflation should be muted by the unfolding economic slowdown.

The causes of slow growth…

The most direct explanations for sustained low growth and slow inflation are structural changes in the economy, spanning demographics, productivity, and debt overhangs. Nominal GDP growth comprises real growth and inflation. Real growth in turn boils down to growth in the labour force and in productivity.

Deteriorating demographics...

In most high-income countries, labour forces are growing more slowly, societies are ageing and both the labour force and overall population are likely to shrink in future. These prospects are very difficult to change because demographic trends typically persist for generations, and because the rules or strong incentives required to change household behaviour are too intrusive for most societies. It’s therefore difficult to see how labour force growth or participation can significantly contribute to higher overall GDP growth (though labour reform could decrease underemployment or long-term unemployment – and so boost GDP levels).

What’s more, political and social realities may augment these baked-in demographic trends. The politics of the Brexit referendum, the EU ‘refugee crisis’ and concern about rising European Union (EU) migration from Central and Eastern Europe (CEE), as well as the focus on immigration in US politics all suggest that large-scale migration from the emerging to the developed world may now slow. Furthermore, there seems to be little room for further major shifts by as yet unemployed or underemployed workers into the labour force (such as surging female labour force participation in the United States during the 1960s – 70s).

The productivity puzzle...

Absent meaningful labour-force growth or participation rates, the other source of faster GDP growth would be productivity – but productivity growth has slowed markedly since the financial crisis. This has been the case across all major developed economies.

Productivity is a catch-all for ‘total factor productivity’ – the output per unit input of the factors of production – land, labour and capital. Throughout history, the productivity of land and labour has increased with the application and accumulation of capital.

The good news is that we are in an increasingly capital-rich world – one with ever more abundant financial, physical and human capital. And, though the amount of land is naturally limited, its reallocation from lying fallow or low productivity, small-scale agriculture for urban, industrial or scientific use, for example, can raise both the level and growth of productivity – and, hence, GDP. But the bad news is that, throughout the world, especially in the developed markets, productivity growth seems to be slowing despite technological progress.

A variety of causes likely play a role in explaining low productivity growth in an age of proliferating technology. Among these, one of the most important is no longer the most discussed – namely, that we are still coming out of a credit-financed asset bubble that started in the developed markets before the financial crisis and then spread to the emerging markets during the era of quantitative easing (QE).

Debt-financed consumption and investment bring activity forward in time, compared to financing the same spending from income, which would take longer and delay growth. Debt crises occur when too much debt (usually short-term) has been incurred, after which a lean period of ‘paying the piper’ ensues. Indeed, credit booms usually enable overinvestment, which must then be cut back after a downturn or, worse yet, a financial crisis like the last one.

A blight of investment in the aftermath of financial crises points to lower potential growth as capital accumulation is cut back. Thus, even if productivity growth is healthy in some sectors, overall productivity growth can still fall. And, if productivity and technological progress displace workers in high productivity sectors, labour productivity growth may slow – or even fall – as workers move into lower productivity sectors. There are arguably elements of structural economic change that could impose sustained restraint on productivity growth.

… and of low inflation

Inflation is the rate of change in prices overall. It is not the same as ‘relative price’ shifts, which occur when the prices of some commodities, goods or services change more than others. Relative prices are in constant flux as commodity, labour, goods, services and even money and capital markets shift and re-equilibrate in a normal market economy. Some economic shocks can create large, persistent relative price shifts, and thereby pose risk to inflation expectations. Inflation targets have mostly replaced fixed exchange rates or gold as nominal anchors for inflation expectations in our fiat currency world.

Inflation targets, generally 2% across the developed markets, are set above zero to allow some flexibility for shifts in relative prices to pass through to the overall price level. A 0% inflation target might raise the risks of deflation from technological progress, reform, or competition. On the other hand, the lack of a target or too high a target might unmoor inflation expectations during booms or busts, or in countries with rigid labour, product, or service markets.

Despite the credibility enjoyed by major central banks – markets respond to all changes in signals, as well as actions – inflation is generally below target or falling. Indeed, the credibility challenge for monetary policy is to bring inflation up to target, rather than to reduce very high inflation back to target. Accordingly, and as discussed above, recent signals of monetary policy normalization in our view reflect the recent resilience of the global recovery and the fading of emergency conditions and major event risks.

Thus, despite above-trend growth, Eurozone inflation remains low – and so too do inflation expectations (figure 4). A large part of the recent shifts in headline inflation owes to commodity prices, whose collapse in 2014-15 exacerbated deflation risks and whose recent rise temporarily boosted headline inflation. Now, with base effects falling away after major shifts in key commodity prices, and with weak broad money growth in the Eurozone, self-sustaining rises in core inflation are likely to be modest.

And what about the emerging markets?

Let us now turn to the emerging markets. Here, we expect nominal growth to be lower than in the past, and yet outstrip the developed markets due to rising productivity, better demographics and higher inflation. Indeed, productivity has been rising much faster across a wide range of countries at various per capita income levels, with different economic systems and in different parts of the world (figure 5).

Be warned, however: not all emerging markets are created equal, nor do they evolve in the same way or at the same rate. The differences are in some cases substantial, and are ultimately likely to be reflected in economic and financial performance, though the market often tends toward buying or selling emerging markets as a whole.

While emerging market productivity is generally rising, there are wide variations in both labour productivity levels and growth rates. Furthermore, rising labour productivity has conferred no guarantee of stable or improving productivity. Different rates of inflation and real wage growth have combined to offset or enhance rising labour productivity and generate much more variation in competitiveness via unit labour costs. The mix of underlying causes includes major differences in institutional arrangements, income policies and structural policies like wage bargaining and labour market regulation, as well as differences in fiscal and monetary policies.

These variations in productivity growth and competitiveness speak to varied economic performance across countries, which are typically reflected in differences in real exchange rates, real yields, and credit spreads, as well as exposure to shifts in the terms of trade and global financial conditions – and, thus, market performance.

Higher emerging market inflation implies structurally high nominal rates...

Emerging economies evolve more rapidly than developed economies, and from lower levels of per capita income – almost by definition, though it is true that some countries do not change or grow fast enough to close the gap in living standards with developed economies. But in general, we expect nominal emerging market growth rates to remain significantly higher than in developed markets, even though trend growth has fallen since the financial crisis (figure 6). Higher potential growth and inflation, both target and actual, implies structurally higher nominal interest rates.

Indeed, it makes sense for most emerging markets to have higher inflation targets, often with a range rather than a point forecast. This allows greater flexibility to accommodate relative price shifts during the transition from a commodity-based/agrarian economy to a more diversified and complex economy.

Furthermore, the underlying structure of price-setting arrangements suggests that inflation will remain high. Many emerging markets have tried to actively manage consumer prices, especially food and energy. But, this has almost always been done with price controls, which represent repressed inflation or shortages – or via subsidies, which represent some combination of public debt, taxes, inflation or pressure on future consumption. Either way, such policies are unsustainable in the face of market forces. Indeed, this is why emerging markets have been liberalizing prices and reducing subsidies in recent decades. This, too, points to sustained high inflation and yield differentials as gradual price liberalization feeds shifts in relative prices and headline inflation rates.

Thus, in a structurally yield-starved, low-growth, low-inflation world, emerging markets with higher real growth, inflation and the associated underlying economic vigour will, in our view, continue to stand out as an attractive proposition for developed market investors.

A point inflation target would probably not work well in most emerging economies, because of heavy food and energy weights in consumption baskets and because rapid structural economic change entails those significant relative price shifts. Furthermore, food and energy are priced in US-dollars and over which no emerging market central bank can exert any significant, sustained influence, so appoint target would be very hard to attain, undermining policy credibility.

Conclusion

Our views on global growth, inflation and financial conditions are generally positive for the emerging markets. For all its faults and all the over-hyping by cheerleaders in the past, the asset class will likely continue to occupy a structural and rising allocation within global developed market portfolios. In our view, the current moderate growth/low inflation cycle still has further to run, even though the US expansion is among the longest in the post-war era. The long-term structural developments are probably even more supportive.

A word about risk

Our positive view of the emerging markets does not mean that all is well with the world, or across emerging markets as an asset class – there are still major event risks, as well as serious slower-burning challenges out there. But, despite these risk scenarios, the central economic scenario is far more comfortable and encouraging for emerging market inflows, both cyclically and structurally. In Europe, there is still a risk of political crisis or a new eurozone crisis that could arise from Italy’s 2018 general elections, as anti-EU and anti-euro sentiments have been voiced by several key political parties. There is also still the risk of an acrimonious breakdown in UK-EU relations, or a return of radical anti-globalization rhetoric and an associated policy shift that may yet undermine the open, rules-based, cooperative international economic and financial system.

We judge these risks to be moving from mainstream threats to moderating tail risks that require close monitoring, but have a low enough probability as not to change the underlying investment rationale based on continued low growth and inflation. In the UK, the chastening election defeat of the incumbent Conservative Party is increasingly softening the previous hard Brexit rhetoric, and suggestions are even starting to spread that there might not be a Brexit at all. US radicalism in most areas of politics and policy are being boxed in by checks and balances, competing vested interests and the basic economic and political reality that governing is complex and radical change difficult. There is also a risk of over-tightening by the Fed, the ECB and China – any one or combination of which could be seriously disruptive. We expect the Fed and the ECB to continue giving markets time to adjust by telegraphing policy debates and changes. And, following the example of the Taper Tantrum, they are likely to relent if financial conditions tighten too far, too fast. China’s policymakers have similarly revealed their willingness to ease up if need be, and we have seen that the economy responds rapidly to incremental easing. In addition, devaluations, recessions or slowdowns have compressed emerging markets’ external financing needs, so that downside risks are lower than in the aftermath of the eurozone crisis or the Taper Tantrum. Hence, we expect corrections rather than crises as policy is normalized, and expect emerging markets to perform reasonably well over the course of the current cycle and the longer term.

Important information

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.