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December 2017

A maturing global cycle boosts EM's attractions

After years of underperforming their developed rivals EM economies look set to take the lead as the global investment cycle ramps up

Emerging market economies look set to outpace the developed world after almost six years of underperformance. That’s down to a profound change in the dynamics of the business cycle. With investment set to supplant consumption as the main engine of economic growth, EM countries should benefit most from the trade boost that comes with rising capital spending. 

Global consumption growth has jumped in the past year after being in the doldrums for the previous five and is now 0.9 standard deviations above its long-term average. Meanwhile, consumer sentiment is at its strongest in more than quarter of a century. This suggests that there’s not much scope for consumer spending to drive the world economic expansion further.

But if the consumption cycle is near its peak, the investment cycle is still in its infancy. Having bottomed out in the first quarter of 2016, it started to pick up in the third quarter and was rising at a 3.3 per cent annual pace by mid-2017.  What’s more, survey data suggest investment growth is accelerating further as existing capacity is absorbed and as corporate profitability grows.

Stronger investment goes hand in hand with stronger exports. For the past six years real exports have grown at below their long-term average. Yet after a trough in October 2016, they are now in the ascendancy again. That makes sense because investment is trade intensive – expensive machinery tends to be sourced on the international market.

takeoff velocity

Quarterly trade growth, year on year percentage change, current cycle compared to average rate and to the profile of previous cycles*  

trade chart

*Cycles since 1992, excludes great financial crisis and 2015 cycle. ** Includes all cycles since 1992. The cycle average excluding the GFC and 2015 is 6.7%. Source: Pictet Asset Management, CPB Netherlands, CEIC, Datastream. Data as of 01.11.2017

The current cycle looks most similar to the ones in 1993, 1999 and 2002. If those prove to be a precedent, then world trade is likely to accelerate during the next five quarters, peaking at an annual growth rate of some 11 per cent compared to just over 4 per cent now.

Trade, in turn, tends to amplify global economic activity. And because emerging markets are more sensitive to trade than their developed counterparts – a 1 per cent increase in cross-border flows lifts EM economic output by 0.26 percentage points but by only 0.14 percentage points for developed markets, according to our models  – they are likely to be the key beneficiaries of this upswing.

This has major implications for financial markets. First, EM currencies should continue to appreciate against the US dollar. Second, EM equities’ price to book ratios are likely to increase relative to those of their developed market peers. And, finally, EM value companies can at long last be expected to do better than EM growth stocks, having underperformed since 2011.

The global economic cycle may be getting on, but that’s no reason to fear its imminent demise. And well-positioned EM investors are particularly likely to benefit.