Accelerated by the COVID pandemic, secular trends are disrupting the global macroeconomic environment. Accordingly, we have updated our framework for gauging risks and opportunities in emerging markets (EM). Over the past two decades, emerging markets have typically been “condition takers,” each country having some degree of sensitivity to Chinese economic growth and U.S. interest rates.
Yet we believe these traditional external drivers will ebb in importance. In fact, we foresee slower Chinese GDP growth dampening its influence on EM business cycles. And the “low for longer” U.S. interest rate backdrop should lessen the U.S. Federal Reserve’s influence on capital flows to emerging markets, in our view.
Going forward, we believe emerging markets likely face a more complex set of external drivers including the U.S.-China rivalry, climate change and mitigation efforts, rapid technology diffusion, and political populism. We discussed these factors at our Secular Forum in September, which included PIMCO’s global portfolio management team and guest speakers renowned for their expertise in economics and public policy. We anticipate it will be increasingly important to judge EM countries’ sensitivities to each of these disruptors.
The result should be volatile and less synchronized global economic growth, with more differentiated investment opportunities across countries. We expect the last decade will likely be a poor guide to valuations and future returns. In our view, active managers who understand how these disruptions affect different EM economies and asset classes should be better positioned to assess risk premiums. Indeed, our Secular Forum speakers from Argentina and Brazil both found assets in their countries attractive.
Like most countries, EM public debt levels surged to all-time highs during the pandemic. Nonetheless, COVID was not a game changer for EM balance sheets at the aggregate level. Most debt remains denominated in local currency (not foreign currency-denominated, a catalyst for many past crises), private sector borrowing did not pick up, and inflation seems to have remained subdued. Looking forward, low interest rates around the world should help contain EM debt- servicing costs despite these higher public debt levels. Accordingly, we expect most EM countries should remain creditworthy.
The bigger secular questions lie around the risk to future growth prospects.
At first glance, it appears that not much has changed, at least relative to the longer-term experience defined from the 1980s onward. Utilizing an “EM macro risk index” that amasses key economic and financial variables across 40 countries, we find no material change in average EM growth prospects relative to the past 20 years, inclusive of the COVID period.
However, against this evidence of resilience, we identify two potential complications. First, regional differences have grown more extreme: We believe the risks to future growth have increased in Latin America, China and Africa, while growth prospects have improved in emerging Europe and Asia ex-China.
Second, there are signs of stress below the surface of these risk measures (see Figure 1). Social distress and rising unemployment brought on by high COVID infection rates and delayed vaccination programs seem to have weighed on productivity growth and squeezed household incomes with higher food and energy costs. Many countries’ growth models must evolve, in our view. Some may while others may not.
We take a humble approach in attempting to trace out the risks and potential opportunities from the various sources of disruption we foresee over the secular horizon. In what follows we sketch out the risks and opportunities that we anticipate from each of these secular disruptors: i) slowing Chinese growth, ii) political populism, iii) climate change and mitigation efforts, and iv) rapid technology diffusion. We believe this framework must be applied country by country to identify potential investment opportunities over the secular horizon.
A more fragile China as growth downshifts
Some of the secular implications of an evolving U.S.-China rivalry have become clearer over the past year. Likely driven at least in part by concerns around U.S. containment policies, the Chinese government appears to be transitioning away from rapid debt-driven, investment-led growth in favor of slower but more equitable growth. We believe this will weigh on those countries most dependent on demand from China, either directly through exports or indirectly through commodity prices. We expect this disruption to fall heaviest on non-energy commodity exporters.
China’s efforts to contain debt and property investment will likely entail important risks to the global outlook. If they were to lead to a classic recession, we could see currency depreciation as a source of domestic stimulus. Such depreciation likely would send deflationary ripples through the rest of the global economy and put downward pressure on the entire EM currency complex.
On the other hand, just as Japan’s downshift to slower growth in the 1990s led to a rebalancing of internal growth and a smaller trade surplus, we would not rule out a similar trend for China. Japan accounted for 24% of global growth at the end of its boom phase in 1990. This share fell to just 1% during the 1990s. And yet global growth rates were largely unaffected, with an offsetting acceleration in the U.S. and Europe. If China exports less but imports more given its greater focus on consumption over investment, a similar dynamic could take hold.
There is also the supply side of the global economy to consider. Amid apparent growing Western backlash against China’s industrial policies, Chinese companies may turn to regionally oriented supply chains, creating barriers to trade in technology that could threaten growth in the fastest-growing sectors in many economies.
Relative winners and losers are unclear at this stage, but this shift should also be an important source of secular differentiation across countries. Consider Vietnam, a country that has already been more successful than others at attracting parts of the global supply chain. Other countries are trying to emulate this success. We expect more of these gains to occur in Asia, but will also watch countries in Latin America for signs of success.
Income inequality and the ramifications of populism
Our secular session on emerging markets focused mostly on the potential disruption from populism. Our conclusions were downbeat. Although China and the U.S. are both beginning to address widening income inequality, we expect inequality within most EM countries, and between EM and developed markets (DM), to get worse over the next decade.
Political fragmentation – as distinct from populism – is seen as likely endemic, and tends to reduce the ability of governments to garner consensus on much-needed structural reforms. Our speakers noted that in Latin America at least, they believe mean reversion from political extremes back to centrism occurs only after populism hits a wall. For EM countries that borrow mostly in local currency debt, these walls likely often take longer to hit.
One variable to watch is demographics. Parts of Asia and emerging Europe are experiencing DM-like challenges with aging populations. Latin America, Africa, and South Asia retain younger populations that are typically associated with faster growth. But amid rising DM protectionism and greater automation in manufacturing, these favorable demographics may also be correlated with growing social unrest. Consider that even countries like Chile and Peru, which we consider to be EM role models, are suffering from their own strains of populism. So at best this is likely a mixed bag even for countries with younger populations. The risk of a return to discredited heterodox policies appears to have gone up everywhere in the world.
As a result, we believe it will become even more important to incorporate into our analysis early warning indicators for lower-quality frontier markets that may be at higher risk of hard debt default. Likewise, it will be important to understand the behavior of the IMF and other official lending institutions, especially what appears to be a greater tolerance for pre-emptive sovereign debt restructuring and a greater use of capital controls.
Climate change and the transition from brown to green
As the countries we believe to be most affected by global warming, emerging markets may have the most to gain from a speedy transition from brown to green. With the ongoing rise in ESG-oriented mandates, we will be watching for phrases like “a just transition.” This phrase captures the idea, which we believe will increasingly take hold among investors, that capital flows to EM should be linked to providing support for those countries, sectors, and individuals that potentially stand to lose the most economically, and where green benefits may be greatest.
Consider that we are coming off what we believe to be a decade of underinvestment in most EM countries. Thus, we expect higher private and public investment in clean energy sources should become an important driver of dynamism. For some, the scale of the green transition can be viewed as analogous to the positive demand shock of the early 2000s that resulted from China’s boom. However, this boom is likely to be longer lasting and far narrower in scope. Green technologies, including renewable energy, electric vehicles, hydrogen, and carbon capture, tend to be more metals-intensive than their fossil fuel-based equivalents. Accordingly, the transition to green is likely to intensify demand for major metals, including copper, nickel, cobalt, and lithium. Once again, we’ll look for those countries and companies that potentially stand to benefit the most.
Importantly, the transition from brown to green may even benefit some of the lowest cost energy producers. The backlash against new investments in brown energy within DMs has contributed to carbon energy supplies being less elastic to accelerations in demand. Rising oil prices imply a likelihood of strong growth and fiscal outcomes for the lowest-cost energy producing EM subset.
While climate mitigation can work in the opposite direction too, harming the more fossil fuel-intensive manufacturers we are not overly concerned. Based on current timetables, it appears these risks are only beginning to build, and are still likely well beyond our secular horizon.
However, the transition costs outlined above are likely to entail higher energy prices and (given the importance of energy inputs to food production) food prices across many EMs. Accordingly, we expect greater inflation volatility and more acute tension between monetary policy’s typical key objectives of stable inflation and full employment. Inflation rates within emerging markets may become less synchronous – again offering an important potential source of differentiated performance for active managers.
Accelerated adoption of new technology
Accelerated automation is likely to weigh heavily on lower value-added production and low-skilled employment. Higher unemployment levels may increase social unrest where governments prove unable to help reallocate labor to other sectors. The sun was already seemingly setting on macro stabilization reforms in many EMs prior to the pandemic. Passing reforms against a backdrop of high unemployment and rising costs from the green transition is likely to be doubly difficult.
And yet, we believe the potential gains for emerging markets from accelerated digitalization are substantial. Whether as a tool to provide public services or for financial inclusion by broadening societies’ access to credit, we view accelerating technology diffusion as a net positive for most emerging markets. The key challenge will likely be in providing opportunities for those displaced by the shift.
We may be embarking on a new regime for emerging markets investing.
Of course, not everything is likely changing. Despite the COVID-related rise in sovereign debt, we believe external credit generally will remain intact, albeit with greater bifurcation between the default-remote countries and a small subset of highly fragile countries.
We believe EM local markets continue to offer a wide range of opportunities. This is where the larger risk premiums will tend to be found because traditional growth models are being disrupted and low inflation can no longer be taken for granted, in our view.
We continue to foresee exchange rates as the primary pressure release valves in countries that borrow primarily in local currency.
But in the short run, the burden on tighter monetary policy to compensate for fiscal risks may provide a strong catalyst for exchange rate appreciation, even as it acts to slow growth.
Lower-quality frontier countries are likely different. Those countries, in our view, will resort to programs backed by multilateral funding and, in some cases, external debt defaults. Our investment framework incorporates what we believe to be these “black hole” risks. However, we also believe that greater weight should be placed on liquidity and policy risk as various forms of capital controls and unconventional market interventions return to the EM policymaker toolkit.
Despite the relative lack of risk premium, our view is that Asia is likely to offer a more diverse set of opportunities going forward, reflecting simultaneous efforts to reorient supply chains, upgrade value-added manufacturing capacity and to rein-in areas of over-investment in China.
In general, we believe EM risk premiums stand out favorably, albeit with plenty of volatility to be expected along the way. Indeed, while our secular speakers expected conditions in Latin America to worsen before they improved, they also found current risk premiums embedded in local and external debt attractive.