Are you concerned about a slowdown in China?
The slowdown in China has been the main culprit for last year’s market panic, but against the backdrop of economic challenges and ongoing trade conflicts, China’s circumstances are largely manageable. Its transition towards a service-oriented, consumer economy is creating concerns because of the resulting growth deceleration, but it is a necessary step for achieving sustainable levels of growth.
Looking forward, any stimulus will proceed in dribs and drabs in China, but the credit taps are unlikely to be opened wide like they were in past periods of slowdown since that would go against the country’s need to rebalance the economy and clean up the financial sector. Rather, China might implement reforms focused on redistribution of wealth and resources within the economy, targeting the hundreds of millions of people living in urban areas who don’t have access to healthcare and education.
Even at a slower 5% pace over the long term, China will still account for 30%-40% of global GDP growth, making it the world’s single largest growth engine behind the United States. However, the future drivers in China are going to be quite different from those of the past 30 years. Just a decade ago, China was running a nearly 10% current account surplus relative to GDP, a number that is now closer to zero. This externally fueled supernormal growth is largely evaporating. In 2017, China created one-third of new unicorns [companies with market values of $1 billion or more] globally, and 7 of the top 10 in terms of valuation. These companies will continue to grow in importance, and many are likely to generate strong returns for opportunistic investors.
After a significant correction in the market, do you believe fragilities in the emerging market landscape may be exaggerated?
Sentiment turned excessively bearish as investors fled emerging markets, but we believe the emerging market fragility is largely overrated for a number of reasons. Current account imbalances across countries have narrowed overall since their pre-financial crisis peak. China, with its exporting prowess, has long been considered a leading culprit in generating these global economic imbalances but has now essentially rebalanced its economy away from exports towards domestic consumption in a remarkable way that doesn’t get media coverage. Indeed, it has recorded its first quarterly current account deficit in nearly 17 years.
We believe that Turkey and Argentina are anomalies. Inflationary pressures have subsided across emerging markets. The problems in places like Argentina and Turkey are not representative of other emerging market countries, as most do not have significant structural funding problems like Argentina and Turkey do. While Turkey does need a massive recession for several years to pare its debt and deal with its fiscal imbalances, we don’t foresee a contagion effect. The risk is just not there in terms of foreign debt, current account deficits, or an overheating economy. What we are experiencing is a “U.S. dollar versus the world” circumstance, rather than just vs. the emerging markets.
Can emerging markets take the lead on technology?
The emerging world has largely become an incubation center for powerful themes such as technology. Over the past 5-10 years, technology has had a profound effect on economies across the globe, but the impact is felt most in the emerging markets. The lack of development in the physical world allowed many countries to leapfrog directly into the virtual world in areas like internet search, e-commerce, and financial services. This is a unique circumstance that supports massive scale in certain technologies. There is also an enormous amount of talented tech professionals, many of them located in China, and that enables emerging market companies to develop new areas like artificial intelligence and machine learning.
Is China really making good on its transition to a consumer-led economy?
The economy is slowing today because the historic growth engines of investments and exports are fading, but the consumer is taking up the baton. Despite current economic weakness, this trend will inevitably bring exciting opportunities for investors as real options emerge from sectors outside of the traditional exporters selling cement, steel, or commodities. Sectors and companies with nuanced and differentiated options will emerge.
Another legacy issue being resolved in China is the misallocation of capital caused by a decades-long real estate boom. Overdevelopment of the real estate sector has long inhibited private investment. With the ongoing deleveraging measures, credit tightening, and curbs on speculative property purchases, we are seeing a transformational shift of capital allocation out of real estate and a boost in the vitality of private investment that promotes real economic growth. In addition, China has fiscal capacity like no other nation on earth—a low fiscal deficit relative to GDP, and huge reserves of assets to bail out banks, if needed. China has achieved a level of urbanization in four decades that the West took two centuries to accomplish, but the economic restructuring in China is not yet complete. We are optimistic that further structural changes, including SOE [state-owned enterprise] and supply-side reform, will transform traditional industries and reinvigorate the economic system through earnings growth improvement.
Are there other drivers for recent volatility beyond the perceived weakness in China and the strong dollar?
There is a confluence of other contributing factors, ranging from geopolitical frictions, a tightening world market, and the global rise of populism. Having withdrawn from a trans-Pacific trade deal and the Paris climate accord, and having slashed its involvement at the United Nations, the U.S. is essentially retreating from global engagement. At the same time, the U.S. continues to slap penalties and a host of sanctions on Russia and Iran, while escalating trade tensions with China. The foreign policy adopted by the Trump Administration has encountered an increasingly skeptical global audience and is creating some vulnerability for emerging markets.
Oil prices have also played a role. The strength of crude prices since mid-2017, alongside weak currencies, have put idiosyncratic pressure on growth, balance of payments, and local interest rates. Increasing energy costs will affect profit margins and corporate earnings, while monetary policy tightening will drive inflation and exchange rate volatility. The outlook for oil prices looks worrying amid the prospect of significant tighter global supplies. However, it is worth mentioning that emerging market equities are no longer tied to commodities to the extent they were historically.
The populist surge has become more of a global story than a western one. Right-wing populist and nationalist governments are also in power in Brazil, Russia, Turkey, India, Israel, and Poland. Amid the uproar over Trump’s “zero-tolerance” border policy, anti-immigration populism is also driving the agenda in Europe.
Brexit, as an expression of British nationalism, is also regarded as a revolt of the people against the elites. With German Prime Minister Angela Merkel announcing her intention not to run for re-election, and her party anxiously watching the rise of the far-right Alternative for Germany party, it’s likely her conservative coalition will also begin sounding right-wing populist themes. In Japan, Prime Minister Shinzo Abe has also taken his conservative Liberal Party in a nationalist direction.
The end of quantitative easing globally is influencing markets. The Bank of Japan and European Central Bank are tapering their bond purchases, while the Fed has long stopped increasing its stockpile of bonds and is now shrinking its balance sheet. The end of quantitative easing in developed economies had spillover effects on emerging markets and exacerbated market volatility in 2018.
What does the future hold?
We believe China will be fine as the country transitions towards slower but more sustainable growth, while maintaining a 30% to 40% contribution to worldwide growth. The emergence of U.S. growth challenges will largely alleviate the worries about dollar strength and rate hikes. And with big swings in structural reforms across emerging markets—be it more prudent macroeconomic efforts, deregulation and privatization aimed at productivity enhancement, or social reforms focusing on boosting social mobility and reducing dual-track challenges in growth—big leapfrog opportunities emerge. We are most optimistic about the emerging markets for their significant number of extraordinary, competitive companies rising and taking the global spotlight.
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Our equity and fixed-income investments, who spend considerable time in these markets, share their insights on where they believe the greatest opportunities lie. Our Innovation Index also demonstrates emerging markets may lead the next wave of technological breakthroughs.
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