JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

Fundamentals:
From Poster to Problem Child: Whats in Store for EM?

After a decade where emerging markets were seen as the engines of

global growth, emerging markets are currently undergoing a growth
slowdown that has taken most forecasters by surprise. Does this signal a
change in the fortunes of these economies?
In this edition of
Fundamentals,
Emerging Market
Economist Erik
Lueth examines
the drivers of the
slowdown and assesses whether
slower growth is transitory or here
to stay.

INSIDE:
Market overview:
Lower global
productivity
Snapshot:
US housing still
early cycle
UK forecast:
Political impact

At LGIM, our emerging market (EM)

analysis focuses on 16 of the larger
economies. We calculate trend growth
in these 16 economies was 3.5% in 2014
(simple average), down from 5% in the
2000s and 4% in the 1990s (figure 1).
The slowdown stands out for a number of
reasons. It is synchronized across most
emerging markets, but without the sorts of
crisis that weve seen in the past. It is also
longer lasting: synchronized slowdowns
usually last one to two years, while this
one is in its fifth year. Furthermore, it is

happening against a recovery in developed

markets, something we observed only once
before during the Asian crisis.
DEMAND VERSUS SUPPLY SIDE
One natural starting point is to ask whether
the slowdown is demand or supply side
driven, the assumption being that the latter
has more lasting effects. If the EM slowdown
were demand side driven we would expect
it to be accompanied by falling inflation
and rising current account balances. In the
case of a negative supply shock we should
observe the opposite.

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

02

Figure 1. EM growth slowdown

are considered more cyclical,

if protracted. Actually, in terms
of final global demand, China
hardly slowed, as growing size
compensated for lower growth
rates. Hence, the combined
demand slowdown of the four
largest economies, the US,
Europe, Japan, and China was
almost entirely due to the three
developed markets (G3).

10
8
6
4
2
0
-2
-4
-6
1960

1965

EM16

1970

1975

1980

1985

1990

trend

1995

2000

G7

2005

2010

trend

Source: Macrobond, LGIM

This result is not driven by a

few outlying economies. As
figure 2 shows, a majority of
countries show symptoms of a
supply side shock. This holds
irrespective of whether inflation
or current accounts are used as
the yardstick. Another pattern
emerges clearly, namely that all
countries hit by a negative supply
shock can be characterised as
commodity exporters.
THE COMMODITY SHOCK
That the drop in commodity
prices played a major role in the
EM slowdown is borne out by
other evidence. Both the surge
in EM growth in the run-up to
the global financial crisis and
the recent growth slowdown
coincided with commodity booms
and busts, respectively. Also, on
average, commodity exporters in
our sample experienced sharper
slowdowns than countries that are
best described as manufacturing
exporters.

commodity prices, particularly

metals. It accounts for half of
the worlds metals consumption
and for all of the recent growth in
demand. But, as China rebalances
away from investment and
construction its appetite for
commodities has waned. Copper
consumption slowed from 33%
growth in 2007 to 15% in 2014,
while aluminium consumption
slowed from 43% growth to 10%
over the same period.
Chinese rebalancing is expected
to last for many years. Hence,
there is little chance that this EM
growth driver will spring back to
life any time soon.
WHAT ABOUT EUROPE AND THE
US?
Can all of the recent slowdown
be attributed to China and
commodity prices? Probably
not. The US and Europe slowed
alongside China for reasons that

To gauge the impact of the G3

on the EM growth slowdown,
we identified a group of seven
countries that have no direct
China exposure: Mexico, Turkey,
Romania, Poland, Israel, and India.
Specifically, the share of their GDP
directly exposed to final Chinese
demand is below 1% and none
of them, with the exception of
Mexico, is a commodity exporter
(Mexico exports oil whose price
fell only recently).
These economies are closely
correlated with the G3, e.g.
growth picked up while China
is still slowing, but even these
economies exhibit a secular
growth decline that G3 economies
fail to explain.
For each of the six economies,
we model growth as a function
of their key G3 trading partners.
Since the first quarter of 2007,
there has been a growth

Figure 2. Growth - inflation dynamics

14
Change in inflation 2014 vs 2012,
ppt

The evidence is quite striking.

Average inflation for the EM
sample jumped from 6.6% in 2010
to 9.8% in 2014. At the same time,
the current account turned from a
surplus of 0.6% of GDP to a deficit
of 1.2% of GDP, before recovering
somewhat in 2014 on the back of
weaker currencies.

ARG

12

Negative supply shock

VEN
(off chart)

10
8

Positive demand shock

6
4
CHL

RUS

0
THA

-2

Negative demand shock

-4

IDN

MYS TUR

MEX BRA

ZAF
PHL

COL

Positive supply shock

CHN

POL

-6
-7

-6

-5

-4

-3
-2
-1
Change in growth 2014 vs 2012, ppt

IND
2

China has been the key driver of

Source: Macrobond, LGIM

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

03

Figure 3. Growth of EMs without China exposure

we could see a long spell of

lower EM growth. Past issues
of Fundamentals (most recently
October 2013) have dealt with
the risk of balance of payments
crisis which looks contained.
Here, the focus lies on sovereign
debt defaults.

8
6
4
2

0
-2
-4
2007Q1

2008Q2

2009Q3

2010Q4

Explained by US/EU growth

2012Q1

2013Q2

Unexplained

2014Q3

Total growth

Source: Macrobond, LGIM

This means we should not put too

much faith in the G3 returning EMs
to past growth rates not even our
manufacturing exporters.
GLOBAL FINANCIAL CONDITIONS
To what extent has the EM growth
acceleration over the 2000s
been driven by loose financial
conditions globally? This is an
important question, since the
easiest monetary stance on
record is about to be unwound
and this could further worsen the
EM growth outlook.
Dollar financing costs for EMs
dropped from 18% at the height of
the Asian crisis to 6% today. A large
part of the decline was due to credit
spreads (and possibly improved
fundamentals), but the secular
decline of US yields also played an
important part. EM local currency
yields are also strongly correlated
with US yields. Even EM policy
rates tend to follow US policy rates,
as EMs try to shield their export
and manufacturing sectors from
exchange rate swings.
If low US rates had been
instrumental in explaining the

EM growth spurt of the 2000s,

we would have expected more
financially open economies
(where we measure financial
openness as the sum of foreign
assets and liabilities over GDP) to
have done particularly well. This
is not what we observe (figure
4). For example, the decade
following 2001 saw emerging
markets grow 0.66ppt per annum
faster than the previous ten
years. However, it was financially
more closed economies that
experienced the largest growth
spurt, with growth accelerating
by around 1.2ppt per annum,
compared to no change for
financially more open economies.
As with our analysis of demand
and supply-side effects, the
results are broad based, rather
than driven by one or two
outliers.
But if higher global interest
rates lead to EM debt crises,

On the one hand, we dont expect

interest rate hikes similar to the
1980s, but we note that public
debt levels are higher than they
were in 1980 and 1997. We can
assess the combined effect by
multiplying US 10-year yields
with EM debt levels. Assuming
US 10-year yields of 4.5% over
the medium term, this measure
would return to 2005 levels when
defaults ran at just two per year
hardly an EM debt crisis.
CONVERGENCE
Emerging markets had a very
good decade following 2000, and
that is unlikely to repeat itself

Figure 4. Growth differential between following and preceding decade

2.0
percentage points

slowdown of three percentage

points, half of which can be
explained by weaker G3 growth,
while half is due to other, probably
more structural factors (figure 3).
This is not driven by a few outliers,
but holds for each of the six
economies.

Figure 5 shows how the incidence

of defaults and restructurings
increased when the US raised
rates in the 1980s. Also, sovereign
debt crises have become
unusually rare in the face of zero
US policy rates. This is almost
certainly going to change. Will
sovereign defaults merely return
to normal levels or will EMs fall
like dominos?

1.5
1.0
0.5
0.0
-0.5
-1.0

-1.5
-2.0
1990
All EM

1992

1994

1996

Financially more open EM

1998

2000

2002

2004

Financially more closed EM

Source: Macrobond, LGIM

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

04

obviously conservative since

many of the countries we look
at are still far away from the
technological frontier.

Figure 5. US monetary policy and the frequency of EM sovereign debt crises

20
15
10
5

0
1954

1961

1968

1975

1982

1989

Number of debt crises

EM interest costs (% of GDP)

1996

2003

2010

2017

Fed Funds Rate (%)

Source: Macrobond, Reinhard and Rogoff (2011)*

One way to answer that question

is to forecast the growth
contribution of the key factors of
production capital, labour, human
capital and productivity.
We estimate the relationship
between the growth contribution
of capital and GDP per
capita (relative to the US, the
technological frontier) using data
for 80 countries over 30 years. We
find an inverted U relationship
with a peak at 68% of the US level.
In 2014, the average GDP per
capita of our 16 emerging
economies amounted to 31% of
the US level, meaning that the
growth contribution of capital is
far from peaking. At the current
level, capital accumulation
contributes about 1.8 percentage
points (ppt) to growth.
The contribution of labour is
backed out from UN projections
of the working age population.

For the EM16, this contribution

has fallen since the early 1970, but
remains positive until 2040.
Human capital is calculated using
years of schooling: the return on
one year of schooling is about
7%. Countries average years
of schooling are projected to
increase up to 12.5 years. This
marks the level where the US has
stabilised and no country has
exceeded it. Based on this we see
that the growth contribution of
human capital remains steady
around 0.5ppt until 2025. After that
the contribution starts to decline
as more and more countries reach
the 12.5 years threshold.
The big unknown is total factor
productivity. Here we assume
a growth contribution of 0.9ppt
which the US managed to achieve
at the technological frontier
over the past 50 years. This is

EMERGING MARKETS TO
OUTPERFORMJUST BY LESS
Our analysis suggests that much
of the EM growth slowdown
seems to be driven by structural,
more persistent factors. Even
for manufacturing exporters,
lacklustre US and European
growth only explain half of the
slowdown and so may be less of a
boost on the upturn. On the bright
side, global monetary conditions
dont seem to have a discernible
impact on growth, limiting the
downside impact of US tightening,
though the impact on EM
financial markets could be more
pronounced. Finally, even under
less favourable conditions, EM
growth should continue to exceed
developed market growth.

Figure 6. EM potential growth (simple average)

5
4
3
%

in this decade. But EM growth

has tended to exceed developed
market growth even before 2000.
Is that likely to continue or has
the catch-up story run its course?
After all, EM income levels have
risen, populations are aging,
and more emerging countries
will provide schooling for as
long as seen in most developed
economies.

This crude measure of potential

growth also suggests that part of
the EM slowdown is structural, as
labour force and human capital
growth have been slowing (figure
6). However, the average EM
growth rate is projected to stay
well above 3% through the middle
of this century and therefore
exceed developed market growth
rates by a healthy margin.

2
1
0
-1
1992

2004
TFP

2016
Capital

2028

2040
Labour

2052

2064

2076

Human capital

2088

2100

Growth

Source: Macrobond, LGIM

*C. Reinhard and K. Rogoff, 2011 From Financial Crash to Debt Crisis American Economic Review, Vol 101, pp 1676-1706

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

05

Market overview:
Lower global productivity
Productivity or worker
output grew at its slowest
rate last year since the
turn of the millennium.
Touted by central bankers
and economists as one of
the largest influences on
living standards across both
developed and emerging
economies, the lower
average productivity was
particularly pronounced in
mature economies. Whilst
softer data continued to
dominate financial headlines
over the month, with the
Bank of England lowering
this years growth forecast
and Chinese data remaining
soft, equity markets have
proved resilient.

UK

US

Decisive conservative victory

Dollar dominates

Despite polls predicting a very

different result, the Conservative
party won the General Election,
even managing to gain a small
majority and therefore govern
without needing to seek support
from other parties. As a result, its
commitment to hold a referendum
on the UKs position in Europe by
2017 will go ahead uncontested by
a coalition partner. The possibility
of a Brexit is a hotly contested
issue and whilst there is a long
way to 2017, its likely that the
economic situation on both sides
of the Channel at the time of the
referendum will significantly affect
the vote. Over the month, equity
markets have performed well and
government bond yields are higher
(moving in the opposite direction
to prices), particularly at the long
end of the yield curve.

The latest US core inflation report

bucked the recent trend in the
US by beating expectations. The
stronger inflation print triggered
further strength in the US dollar as
market participants began to price
in an increased likelihood that the
US Federal Reserve could raise its
data-dependant rates sooner than
recently thought. Fed Chair Yellen
commented that although labour
markets are not yet at full strength,
tightening steps are appropriate
at some point this year, which
further supported the change in
sentiment. Ten-year US treasury
yields are currently at 2.20%,
representing a significant uptick
over the month, while US equity
markets have also managed to
beat all-time highs over the month.

Figure 1. Global equity markets

130
120
110
100
90
80
Dec 2013

Apr 2014
S&P 500
Eurostoxx 50
MSCI Emerging markets

Aug 2014

Dec 2014
Nikkei 225
FTSE All-Share

Apr 2015

Source: Bloomberg L.P. chart shows price index

performance in local currency terms

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

EUROPE

Depreciating euro
The euro has weakened on
renewed fears surrounding
Greece. The political wrangle
between Greece and Germany
looks set to continue: Germany
doesnt want to be seen as
responsible for forcing a Greek
exit but at the same time, the
Greek Interior Minister has openly
stated that Greece will not be able
to meet its next IMF payment on
the 5th June. The difference in
government tack is evidenced by
each countries bond yields, with
the German ten-year bund yield
at 0.61% versus 11.39% for similar
maturity Greek government
bonds. However, even German
yields are significantly higher,
with ten-year bund yields rising
significantly from the 0.08%
all-time low seen in late April.
European equity markets have
however managed to move
higher as the weaker euro is seen
as making many of the regions
exporters more competitive.
JAPAN

Yen falls
The Japanese yen has weakened
against the US dollar significantly,
bringing it close to 2007 levels.
Most of the weakness is attributed
to the divergence in monetary
policy taken by the Bank of Japan
versus the US Federal Reserve,
especially as the Bank of Japan
looks very much set to continue
with its massive programme of
quantitative easing. The weaker
yen has provided a small boost
to the export-sensitive Japanese
stock market with the Nikkei up
since our last Fundamentals.

06

Figure 2. 10-year government bond yields

7
6
5
4
3
2
1
0
Dec 2013

Apr 2014
Germany

US

Aug 2014
UK

Dec 2014
Italy

Spain

Apr 2015
Portugal

Source: Bloomberg L.P.

ASIA PACIFIC/EMEA

FIXED INCOME

Another China rate cut

Cautiously long

China cut interest rates for

a third time in six months in
May on softer-than-expected
inflation data. It marks further
commitment from the Peoples
Bank of China to support
its economy and liberalise
its interest rate market. The
Mutual Recognition of Funds
initiative was also announced
this month, which will allow
fund managers to sell Hong
Kong-registered funds directly
to Chinese investors for the
first time further evidence of
Chinas commitment to open its
capital markets. Both the further
stimulus and liberated capital
markets have had a positive effect
on Chinese equities. Elsewhere
in emerging markets, the small
recovery in commodities,
including iron ore, has provided a
welcome boost.

Many credit investors are said

to be currently positioned as
cautiously long or tentatively
pro-risk, for fear of been caught
out in an illiquid market. Trying
to find a concrete view on the
future direction of government
bonds and rates is equally hard
to quantify. Various central banks
have proved cautious not only
in monetary tightening action
but in wording around possible
tightening. Should the US raise
rates as early as June, this will
have significant implications
across the globe. For now, most
developed government bond
yields have moved higher over the
month, albeit from exceptionally
low levels in Europe.

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

07

Snapshot:
US housing still early cycle
Six years on from the financial crisis and the US housing market is still in the doldrums with activity at levels
typically seen in recession (figure 1). The US housing market made little contribution to growth last year,
disappointing the Feds forecast and forcing the FOMC to repeatedly say in its statement that the recovery
in the housing sector remained slow. One concern is that if housing cant grow at todays low interest rates,
then it might never recover. But this misses the underlying healing.

% of GDP

Figure 1. US residential investment

7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
60

65

70

75

80

Residential investment

85

90

95

00

05

10

15

Mean

Source: Macrobond, LGIM

We see a number of positive developments which should lead to a stronger housing market over the next
few quarters. First, while there are still some pockets of distress, pricing on a national basis has now almost
recovered to pre-crisis peaks. This is increasingly eliminating the negative equity which has acted as a
barrier to prevent households from moving home. Second, it has taken a long time to work through the
excess construction of property in the boom years. But now inventories appear lean. With delinquency
and foreclosure rates approaching normal levels, shadow inventory is now almost full absorbed. Third,
homeownership rates have dropped to relatively low levels. All the sub-prime borrowers are now out of
the market. Employment is currently rising by two to three million jobs a year. This is contributing to a
rise in household formation. As the rental market tightens, this should help encourage more people into
homeownership. Finally, households have significantly reduced their debt levels and with low mortgage
rates, debt servicing costs are historically low (figure 2). Credit standards for mortgages have been easing at
a faster pace in recent quarters which means households are in position to begin taking on more debt again.
Figure 2. US household mortgage debt service ratio
% of disposable income

7.5
7
6.5
6
5.5
5
4.5
4
80

82

84

86

88

90

92

94

96

98

00

02

04

06

08

10

12

14

Source: Macrobond, LGIM

Timing a strengthening is tricky, but there are some tentative signs of an improvement from housing starts,
mortgage purchase applications and pending home sales. Given housing is lagging the rest of the economy
it might take a couple of economic cycles to fully recover, but at least housing is unlikely to exacerbate the
next recession, even if this is caused by attempts from the Fed to normalize interest rates.

JUNE 2015

ECONOMIC AND INVESTMENT COMMENTARY

08

UK forecast:
Political impact
UK economy

Price inflation
(CPI)

GDP
(growth)

10-year
gilt yields

Base rates

$/

Market participants forecasts

2015
%

2016
%

2015
%

2016
%

2015
%

2016*
%

2015
%

2016*
%

2015

2016*

2015

2016*

High

1.10

2.40

3.00

3.00

2.90

3.10

1.00

1.50

1.63

1.79

0.76

0.81

Low

-0.10

0.80

2.10

1.70

1.55

1.50

0.50

0.75

1.39

1.40

0.64

0.59

Median

0.40

1.60

2.50

2.40

2.03

2.39

0.50

1.00

1.49

1.52

0.70

0.71

Last month median

0.40

1.70

2.60

2.40

1.98

2.25

0.50

1.00

1.47

1.51

0.70

0.71

Legal & General Investment Management

0.40

1.50

2.50

2.30

2.25

2.50**

0.50

1.00

n/a

n/a

n/a

n/a

Source: Bloomberg L.P. and LGIM estimates

*Forecasts are for end of Q2 2016
**Forecast for end of 2016

The outcome of the UK General Election was quite clear. Television, newspapers and online media of all political
persuasions were of one voice: this was a seismic change, a break with the past or some other hyperbolic
statement as the traditional UK system dominated by two parties appeared to have changed.
That was the political reaction. And markets? Apparently couldnt care less. Take a look at a six-month chart of the
FTSE 100, 10-year gilt yield, or even sterling vs the US dollar and see if you can find the election effect. Sterling and
the FTSE were a bit stronger initially, but quickly gave this back, while gilt yields were quite clearly more interested
in the general sell-off in global government bonds.
This was no surprise to us. Our analysis1 suggested that historically, elections tend not to have a major impact
on markets. Uncertainty around the election was based on the lack of clarity around who would be able to build
a coalition and what its policies would be. Once the Conservatives won a majority, that uncertainty disappeared,
despite the fragmentation of the vote or the success of the SNP and UKIP. Markets were faced with a change only in
terms of removal of Liberal Democrat influence from Tory policies. So no material changes.
Obviously the EU referendum is a potential point of uncertainty. The Bank of Englands not-so-secret plan to deal
with a UK exit attracted headlines, but arguably it would be a poor excuse for a central bank that didnt at least look
at the possible effects. While early in the process, we note that Cameron is already downplaying the potential gains
to be made in negotiations. Furthermore, it shouldnt be forgotten that once the referendum campaign proper starts,
both the Government and most other parties will be backing the stay in camp, as will the business sector.
Aside from the EU issue, what can we expect? More of the same in many areas. There are new anti-strike laws
planned, which will increase the attractiveness of the UK relative to continental Europe from a business perspective.
But the priorities for the government are unchanged from a month ago: keep spending under control and hope that
growth will help bring the deficit down and reduce overall debt. The Government has announced a mini-budget
for July 8, which will clarify the spending cuts highlighted in the campaign where it will be interesting to see if it
is going to follow through on the tough promises on the likes of welfare spending. Beyond that, attention will be
more focused on inflation and the interest rate outlook once more.
Please see Macro Matters: The UK Electoral Eclipse, available via www.lgim.com

The forecasts above are taken from Bloomberg L.P. and represent the views of between 2040 different market participants
(depending on the economic variable). The high and low figures shown above represent the highest/lowest single forecast from
the sample. The median number takes the middle estimate from the entire sample.
For further information on Fundamentals, or for additional copies, please contact jennifer.daly@lgim.com
For all IFA enquiries or for additional copies, please call 0845 273 0008 or email cst@landg.com
For an electronic version of this newsletter and previous versions please go to our website
http://www.lgim.com/fundamentals
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