Not your older brother’s emerging markets :: Goldman Sachs

Not your older brother’s emerging markets
Five macro tailwinds drove stellar performance of EM assets
Five major macro tailwinds, alongside very large risk premia for EM assets,
drove the stellar performance of EM assets in the last decade, when they
delivered historically high returns and comfortably outperformed their DM
peers. Those tailwinds stemmed, to a large extent, from the late-1990s
crises and the sharp rise in the growth impulse from China.
But the structural story for the years ahead is very different
But none of the five major macro tailwinds is likely to repeat itself, and some
may reverse. Moreover, risk premia in EM assets are generally much smaller,
with the possible exception of EM equities. Over the next decade, EM assets
are unlikely to deliver the kind of risk-reward that investors had become used
to in the last one. And absolute returns will likely be much lower.
Not your father’s emerging markets either
The good news is that sovereign leverage is generally lower, only a few
countries are running large current account deficits and fiscal positions are
generally on a sounder footing than in the developed world. But macro
policy challenges have become more acute for many EMs and significant
economic adjustments may lie ahead. Investors also have greater exposure
to these markets than in the past. Hence, the skew of potential returns in
many EM assets has become more negative and differentiation across the
group may be more important than exposure to EM assets as a whole.

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Not your older brother’s emerging markets
Much of the last decade was an unusually strong period for emerging market (EM) assets.
Over that period, EM equities, credit, local bonds and currencies all delivered historically
high returns. They also comfortably outperformed their DM peers (Exhibit 1). While that
story ended for EM equities in 2011, it has continued until very recently in fixed income.
That stellar performance was backed by five major macro tailwinds, alongside a starting
point where EM assets embedded very large risk premia. Those tailwinds in turn stemmed,
to a large extent, from the crises of the late 1990s and from a sharp increase in the growth
impulse from China. In hindsight, it was a golden combination.
The structural story over the years ahead looks different. Of the five major macro tailwinds,
none is likely to repeat itself and some may reverse. A gradual normalisation in US real
interest rates from unusually low levels may be the most important of these shifts, as the
last few weeks have previewed. And the starting point now—with the possible exception
of EM equities—is one where risk premia in EM assets are generally much smaller.
The conclusion is straightforward. Over the next decade, EM assets are unlikely to deliver
anything close to the kind of risk-reward that investors had become used to in the last one.
And absolute returns are likely to be much lower. In that sense, to paraphrase the old
expression, these are not your older brother’s emerging markets.
If the upside is more limited, how does the downside look? The good news is that these are
not your father’s emerging markets either. Sovereign leverage is generally lower, only a
handful of countries are running large current account deficits and fiscal positions are
generally on a sounder footing than in much of the developed world. So the EM crises of
the 1980s and 1990s are also not the likely template. But, as we have argued over the past
year, macro policy challenges for many emerging economies have become more acute and
significant economic adjustments may lie ahead. A long period of strong performance also
means that investors have built up greater exposure to these markets than in the past. So
we think the skew of potential returns in many EM assets has become more negative and
differentiation across the group more important, more like the EM landscape before the
last decade.

Five macro tailwinds for EM in the last expansion
Talking about emerging markets as a group is a dangerous simplification. We have
previously pointed out the differentiation across that universe, and macro circumstances
vary widely across the group. So while we focus here mostly on EM aggregates, we
acknowledge up front that by focusing on the forest we are missing the trees in many
places. But the simplification is also helpful, at least for focusing on big picture trends. The
strength of EM assets over much of the last decade was unusually broad-based. And in
practice, many investors treat the EM universe as an asset class and a discrete part of their
portfolio allocations. That in itself provides clues to its sources.
We focus here mostly on the period since 2003. Any time period is to some extent arbitrary
but this point benchmarks the bottom in risky assets in the last cycle. Much of that decade
was characterised by five macro tailwinds for emerging markets:
1. A sharp increase in the impulse from China and the BRICs to the world
economy. Beginning in the early 2000s, the integration of China into the global
trading system accelerated markedly (Exhibit 2) and its demand growth became a
positive force for suppliers across other emerging markets. That integration
brought with it a period of unusually rapid productivity growth in China itself and a
period of benign inflation alongside strong growth as the rural-to-urban migration
accelerated. With Russia emerging from the messy transition of the 1990s and
India reaping some benefits from earlier reforms, the acceleration in productivity
growth was broader. The result was a sharp increase in the growth impulse from
the large EM economies, a process we identified in our first BRICs projections in
2003. The contribution from EMs to global growth rose from less than 50%
between 1990 and 1999 to around 75% in the following decade and systematically
exceeded even our optimistic expectations (Exhibit 3). This demand impulse
directly benefited China and indirectly benefited its suppliers.
2. A secular rise in commodity prices. Alongside increased China and EM demand
growth, underinvestment in the 1990s (itself partly a consequence of the Asian
crisis) laid the foundations for a long period of tight commodity supply. As a result,
the terms of trade for EM commodity producers rose sharply (Exhibit 4). While the
EM terms of trade improved on average, those of net commodity importers in EMs
did not. But since China and India’s own growth was improving and China’s
demand benefited other regional economies that supplied capital and consumer
goods (Korea, Taiwan) rather than commodities, that headwind proved
manageable.
3. A long (sovereign) deleveraging and improving external balance sheets. The
EM crises of the late 1990s prompted a sizeable return of capital from emerging
markets after 1998, which gave way to capital exports from China and the major
commodity producers. By 2004, EM current accounts had swung from a deficit of
2.3% of GDP to a surplus of 1.7% of GDP (Exhibit 5). With interest rates also falling,
the result was a sharp improvement in the external financing requirements of the
EM universe (Exhibit 6). External debt to GDP ratios fell from 40% to 20% currently.
Reserves were rebuilt and are now 120% of total external debt, up from 25%.
External debt payments fell to 2.5% of total export revenue. The improvement in
balance sheets led to a steady ratings upgrade in EM sovereigns. Not all EMs
followed this pattern. Parts of EMEA bucked the trend and paid the price in the
2008 financial crisis. But improvements have been fairly broad-based.

4. Anchored inflation. In the mid-1990s, average EM inflation was running at over
40%. And while a few outliers dominated that outcome, median inflation outcomes
were also 10%. The inflationary picture improved steadily through the late 1990s
and by the start of the last expansion in 2003 inflation had fallen on average to 7%.
Since then, there have been only modest further declines on average. But the last
decade has seen many countries cement both lower and less volatile inflation than
in the past, reducing a key source of macro instability from the past (Exhibit 7).
5. Falling core real yields. As a ‘price-taker’ in global capital markets, EM economies
have generally found their own financial conditions heavily influenced by real
borrowing costs in the core markets. Several past EM crises have been
precipitated in part by rising core market yields (the debt crises of the early 1980s
and the Mexico crisis of 1994 are examples). Between 2003 and 2011, real yields in
the US and other safe sovereigns fell sharply. The 5-year US real yield fell from 4%
in 2000 to around 1% in 2003 and following the Global Financial Crisis fell to a low
of -1.6% early this year. The path for 10-year yields is broadly similar (Exhibit 8).
The long decline here has provided scope for lower real rates in EMs and
contributed to lower financing costs and easier financial conditions across much of
the EM world.
A virtuous macro circle plus high risk premia was a perfect mix
These five tailwinds were also mutually reinforcing. Falling interest rates reduced debt
burdens. Strengthening currencies helped to contain tradable goods inflation. Rising
commodity prices helped current account positions in many EM borrowers. Improving
current account positions and the resulting EM savings supply helped to depress core
market real yields. So disentangling each factor is hard. But the combination of forces was
extremely benign. Some of these shifts reflected hard choices by EM policymakers and
institutional reforms in several places were critical in cementing the shifts towards a more
stable macro backdrop. But it was also true that the external environment—always an
important driver for many of these economies—was unusually favourable.

These five past tailwinds are likely to be neutral at best…
This cannot be repeated. The landscape ahead over the next few years looks very different
to 2003. The macro stabilisation following the crises of the 1990s has mostly run its course
and the integration of China into the world and the sharp increase in its growth
contribution is also more in the past than the future. If anything, it is the DM world that has
created some of the room to grow that typically follows deep crises.
As a result, none of the five macro tailwinds of the last decade is likely to continue with
much force, and some may reverse. Specifically:
1. The stronger-than-expected growth impulse from China’s integration is
largely complete. Our expectations are for continued high growth from China
over the coming years, although the pace of GDP growth has taken a step down
from prior levels and productivity growth has also decelerated from extraordinarily
high levels. But the process of an accelerating impact on the global economy and
increasing trade integration is probably over. The rate of increase in China’s trade
share and the pace of rural-to-urban migration have both slowed (Exhibit 2). And
we have shown that while the EM/BRICs contribution to global growth is likely to
remain very high, the big rise here is probably also mostly over (Exhibit 3). None
of this spells trouble, but the sharp impulse and positive surprises from this source
are unlikely to be repeated.
2. The long uptrend in long-dated commodity prices is probably over. With a
somewhat lower demand growth profile and a supply response to higher prices in
many commodity markets, we expect a more stable environment for long-dated
commodity prices over the years ahead (Exhibit 4). We expect long-dated energy
prices to remain flattish in the near term and there could be some downward drift
further out, as supply increases further. This means that the best of the terms of
trade boost to EM commodity producers is also over. Where the income gains
from this source have been consumed more than invested, that shift will be more
challenging.
3. External balance sheets are unlikely to improve much further and privatesector
leverage has increased. EM current accounts have deteriorated since 2007.
While China’s reduced surplus dominates that picture, Exhibit 5 shows that the
story is broader and a number of EM economies are back to running current
account deficits after periods in surplus (Brazil, Chile). Cyclical weakness in
developed markets may exaggerate the underlying shifts. But increased
consumption and stronger exchange rates have also weighed on current accounts.
As a result, external debt indicators are unlikely to improve much further and may
in places begin to deteriorate again (Exhibit 6). The long period of improved asset
performance has also seen portfolio exposures to EM economies rise. At the same
time, while sovereign balance sheets have improved, private-sector credit has
risen relative to GDP across EM, in some cases quite substantially (Exhibit 12).
4. Inflation is unlikely to come down much more. We do not expect significant
rises in inflation in EM over the coming years. But with inflation having been
brought lower, the scope to do this again—and its significance to the macro
picture—is limited. The gains from this success are thus also likely to be behind us.
At the margin, we have worried in places that underlying inflationary pressure has
remained quite high in some key EM economies (Turkey, Brazil, India) despite
softer growth, and inflation is running above target in more than half of EM
countries.
5. Real yields in the US are likely to move higher. While we expect the pace of
yield ‘normalisation’ in the US to be gradual, our forecasts are for a slow but
steady increase in US nominal and real yields over the next few years as the US
recovery solidifies and the Fed slowly moves towards exit. The last few weeks
illustrate the potential for that shift to be disruptive. Our forecasts imply that real
10-year yields in the US will be around 0.75% by the end of 2014 and 1.25% by late
2015 (Exhibit 8). The risk is that these shifts take place less gradually, at least for
periods of time.
…which, alongside lower risk premia, suggests more muted returns
To summarise, sitting in 2003, investors in the ‘average’ EM economy looked out on a
landscape that over much of the next decade would feature improving external balance
sheets, an unusually strong China/BRIC growth impulse, rising terms of trade, falling US
real yields and a cementing of moderate inflation. Looking out over the next decade, the
same investors looking at the ‘average’ EM economy are unlikely to face the same China
growth impulse, external balance sheet or inflation improvements, and are likely to see
both higher US real yields and flat to falling terms of trade performance.
At the same time, the valuation of most EM assets is a good deal less attractive than in
2003, as Exhibits 9 to 11 show. EM sovereign credit spreads have moved from 400bp to
110bp on average. Given still low 5-year real yields, this means that the average USD
sovereign credit in EM (excluding Argentina and Venezuela) is still only barely positive in
real terms. EM local 3-month rates have fallen from 5% to 3% in nominal terms (and from
2% to -1% in real terms). The average EM currency is now 10% overvalued and offers carry
of around 270bp compared with 800bp in 2003. Only in EM equities is the valuation picture
not clearly worse. Price-to-earnings and price-to-book metrics are well above 2003 levels
(Exhibit 13), but are not unusually high on an absolute basis, and while they are less
favourable relative to US markets than they were in the late 1990s or in 2003, they are not
as stretched relative to developed markets as in 2007 and 2010.