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Are emerging markets entering a new virtuous cycle?

Barely a year ago, Vale, the Brazilian mining company, was reeling. Prices of iron ore, its principal export, were at an all-time low, investors were ditching its shares and China — the market on which it most depends — looked as if it was heading for a rapid and uncontrolled slowdown.

Fast forward 13 months and iron ore is back in fashion. Vale is producing record amounts and, on the back of a more than doubling in price to nearly $90 a tonne, last week revealed a 2016 profit of $4bn after a loss of $12bn in 2015. Its share price in São Paulo hit a four-year high of more than R$35 ($11) last week, from a low of less than R$7 in January 2016.

Much of that recovery has come since the turn of the year. And while the key factor for Vale has been a recovery in China it is not the only reason driving a revival of fortunes for companies in developing economies.

Prices for container shipping, typically used to transport manufactured goods rather than commodities such as iron ore, are also rising. From less than $500 a year ago, the average cost of shipping a 40ft container from China to northern Europe on a short-term contract has climbed to $3,285, according to Xeneta, a Norwegian company that tracks rates.

East-west trade, in the doldrums for much of the past five years, is picking up. Vietnam’s garment industry, for example, has seen revenues rise from $7bn in 2009 to $26bn last year.

Michael Laskau, a managing director at Nhabe Garment Corporation in Ho Chi Minh City, which supplies retailers such as Calvin Klein, Tommy Hilfiger and Ralph Lauren, says sales are being driven by the US.

“There is no question that the growth of the Vietnamese garment sector is coming from continually strong US demand and the relocation of manufacturing capacity from China to take advantage of our lower costs,” he says.

Sceptics say this is merely another twist in the volatile economies of the emerging world. But others insist it offers a sustainable second coming for emerging markets even as Donald Trump’s presidency is threatening to unstitch the US from the world economy and unpick global trade deals that many emerging markets depend on.

The Trump trade

Central to the optimist argument is the recovery in China over the past year. Fearing a “hard landing”, Beijing steered the economy away from a potential crisis by pumping credit into critical areas such as the housing market. That in turn helped support prices of iron ore and other raw materials supplied by emerging market exporters.

Short-term contracts for shipping a 40-foot container have climbed from $500 a year ago to $3,285 © Bloomberg

In the end it may simply be delaying what many fear is an inevitable credit crunch by adding to China’s huge debt burden. But in the short term at least it has pushed the prospect of disaster to the back of EM investors’ minds.

Nor, the optimists argue, is it all about China. Many feel that Mr Trump will not be able to deliver the promised protectionist measures that threaten to wreak havoc on emerging market exporters. Others believe that the administration will boost global demand through tax cuts and infrastructure spending.

There is even a chance of the emerging world entering a virtuous cycle, says David Hensley, an economist at JPMorgan, in which optimism begets investment, which in turn begets higher productivity and earnings, leading to yet more investment and faster growth.

Beijing’s support for the construction sector has helped spur the EM recovery © Bloomberg

According to the Institute of International Finance, an industry association, growth in gross domestic product across emerging markets surged to an average of 6.4 per cent in January, its fastest monthly rate since June 2011. If confirmed, this will show emerging economies reversing a downward trend in growth that has been in place since the global financial crisis.

Mr Hensley believes the recovery has solid foundations. “What we are seeing in the data is a shift back towards businesses as the driver of global growth,” he says. That businesses should drive growth may sound unsurprising, but such normal behaviour has been disrupted in recent years.

Mr Hensley says the “taper tantrum” of 2013, during which investors fled emerging markets at the prospect of a tighter monetary policy from the US Federal Reserve, followed by the oil price shock of 2014 and China’s stock market rout of 2015, all contributed to a severe tightening of credit conditions. As a result, net capital outflows from emerging economies hit $735bn in 2015, according to the IIF. While the outflows have continued, their pace has slowed.

“This was an incredibly complex period, when the upshot was that global growth slowed and EM growth slowed disproportionately,” Mr Hensley adds. “Then, last year, we began to move away from those shocks and unwind their symptoms.”

Since then, he says, corporate profits have picked up, not just in the US but around the world. This has been matched by recent significant upticks in purchasing managers’ indices (PMIs), the leading indicators of activity that reveal how much trust companies have in the health of their markets.

While PMIs have improved more rapidly in developed markets than in developing ones, they have recently been positive in both. For emerging markets, it is PMIs in the developed world — where demand for their exports lies — that often matter most. And the optimism is feeding through to the real economy, with a rise in manufacturing output.

This would mean little were it not accompanied by a pick-up in investment — crucial in laying the ground for rising productivity and sustainable growth. JPMorgan’s data show a marked pick-up at the end of last year in both corporate profitability and capital expenditure, which the bank’s economists expect to be sustained.

Trade data offer further reasons for optimism. Analysis of export data by Capital Economics, a London-based research group, shows that big emerging market exporters had a strong start to the year, with shipments from China, Brazil and South Korea all growing strongly in dollar terms in January.

To those who worry that, like previous emerging market upturns, this one may be all about commodity prices, the data tell a different story. While the recovery in commodities over the past year has played a big part, and not only in Vale’s 2016 earnings, other exporters, including carmakers in Brazil and electronics manufacturers in South Korea, are also enjoying a rise in overseas sales.

Investors have responded. Flows to emerging market equity and bond funds have begun the year positively for the first time since 2013. Foreign investors withdrew more than $38bn from EM stocks and bonds in the last three months of 2016 but sent more than $12bn back to those markets in January, the IIF estimates.

Sergio Trigo Paz, head of emerging markets fixed income at BlackRock, the world’s biggest asset manager, last year correctly predicted a rally in EM bonds. Now he talks of a “great transition” from unorthodox to orthodox monetary policy, from fiscal austerity to stimulus and from traditional politics to populism.

He argues this shift will benefit emerging market assets, saying that while interest rates may be rising — from very low or even negative levels — so too is inflation. Emerging markets will offer “the only prospect of having any positive real return”, he says.

Furthermore, a fiscal stimulus under the Trump administration will be reflationary for the US and for foreign exporters. “The US has the means to do it. Delivery is three years away but it will be voted on in Congress this summer — and investors have already bought into that quite significantly,” he says.

Iron ore prices have surged over the past year © Bloomberg

The danger lies in populism politics. “Company managers can be projecting their cash flows for the next three years on the basis of reflation and infrastructure spending,” says Mr Trigo Paz, “and then one 3am tweet [from Mr Trump] can unravel everything”.

Chill wind of deflation

China’s influence has not always been positive for emerging markets, especially in recent years. And some analysts remain to be convinced that its economy or the rise of populism present a buying opportunity for EM assets.

When Beijing’s demand for commodities went into reverse China’s producer price index — which measures the cost of goods bought and sold by its businesses — suffered a 54-month negative streak that only ended in September. This triggered deflation across the emerging world, cutting the earnings of exporters and eroding corporate profits.

China’s PPI has now turned positive, surging 6.9 per cent in January. But Michael Power, strategist at Investec, is not convinced that it will end well. “If the renminbi holds [its value] against the US dollar at current levels, yes,” he says. “But I am not sure that it will.”

This he blames largely on a widely forecast strengthening in the US dollar. If this transpires and the renminbi devalues further, China’s downward pressure on global prices will persist. If that happens, businesses around the world will struggle to keep prices and earnings buoyant, undermining the case for investment and growth.

The fragility is further exposed by scrutiny of China’s rising PPI. In the past, any significant move in its PPI has been heralded by a similar move in PMIs for emerging markets as a whole — as rising demand at Chinese and other EM companies would naturally be followed by rising producer prices.

But that is not what is happening. The latest data suggest purchasing managers are not planning any great spending, and yet the PPI has surged.

Supply not demand

Bhanu Baweja, head of emerging markets cross-asset strategy at UBS, says rising producer prices in China reflect supply, not demand. So higher oil prices have corresponded with lower output in the US; the rise in copper prices has been driven by strikes at the world’s biggest copper mine in Chile; even iron ore production, despite Vale’s record performance, was less than expected last year. And Chinese iron ore demand has been driven by a clampdown on backstreet steelmakers using scrap, rather than end-user demand for more steel.

“If what we have seen is driven by supply as seems to be happening, it is hard to make the case that demand will pick up,” Mr Baweja says. “The idea that the global economy is reflating, and will lift all the boats in emerging markets, is getting clouded by the year on year change in commodity prices.”

Mr Baweja agrees that it would be rash to underestimate the impact of rising PMIs or to “stand in the way of that trade”, but questions whether the data really show a significant feed-through into activity.

He argues that, based on history, the level of US new orders to inventories should be on track to deliver a 25 per cent increase in emerging markets exports, but nothing like this has happened. Indeed, the latest data from the US Institute for Supply Management show that while US manufacturers’ orders are rising, their imports are flat.

He notes that, aggregated according to purchasing power parity, the GDP of all emerging economies combined is expected to rise by only half a percentage point in 2017. Any improvement is entirely due to Brazil, Russia, Argentina and Venezuela — the first of those is emerging from two years of recession, the second is hit by sanctions and the last improving its annual GDP growth rate from -10 per cent to -5 per cent.

Central to the sustainability of the emerging market rally will be China’s housing market. Beijing has kept a tight hand on the controls, acting to prevent bubbles but also stepping in to maintain demand. There is, however, now a fear that the market might have peaked, with prices falling in many cities at the end of last year.

A major concern revolves around the amount of credit Beijing has had to pump into the system to keep demand afloat. Mr Baweja notes that last year China’s credit impulse, which measures the change in the pace of credit growth, was on a par with the boom year of 2009, but from a much higher base.

“We may be becoming super positive on emerging markets just as Chinese housing begins to turn down,” he warns.

Not that emerging market assets will suffer in the short term. On the contrary, he says: “In the context of the past five years, corporate earnings in the first and second quarter will look stellar.”

Investors, he says, would be foolish not to join the rally. But they should be cautious about expecting it to last.

Additional reporting by James Kynge

Via FT

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