Emerging Markets Monitor

Total debt in emerging markets has risen strongly since the 2008 financial crisis to reach a high of 186% of GDP in Q1 2017. It is corporate sector debt in particular that has driven the increase, accounting for over half of the total.

Total debt by main region

% GDP

We use a methodology from the Bank for International Settlements (BIS) to identify the long-term trend of the debt-to-GDP ratio. Subtracting this long-term ratio from the current debt-to-GDP ratio gives the excess debt of a market (also called the debt gap). The chart below shows the debt gap* of leading emerging markets.

Emerging private debt gap by markets 

(Q1 2017, % GDP)

 

A debt gap above 10% is a level beyond which the risk of financial crisis rises significantly. Fortunately almost all major emerging markets are below this threshold, especially compared to five years ago.

The only exception is China, where we do not expect a major crisis (read our article).

Excess debt becomes an even bigger problem if it needs to be financed externally, i.e. if a country has a current account deficit (CAD).

Looking back in the chart below at the 2013 taper tantrum—a key episode for emerging market assets—5-year swap rates for emerging CAD countries (the green line) sold off in line with the US 10 year bond yields, selling off even further through early 2014.

By contrast, current account surplus countries (CAS) saw their swap rates remain far more resilient and stay inside the US 10 year yield, with a spread increase of only around 50bps.

The same trend was seen in the currency markets over this period, with CAD currencies depreciating by an average of 15%, but CAS countries by only 3%.

MIXED FORTUNES IN THE 2013 TAPER tantrum

EM CAD & CAS swap rates & US 10 year bond yield (2013-2014)

Then anD now...

Average of key current account deficit emerging markets in 2013 and 2017

There are exceptions, notably Turkey which still has a high current account deficit (5.3% of GDP) and high inflation rate (>10% y/y).

Overall though, we do not believe the emerging market complex is heading for a major correction as US yields continue to rise.

As the chart below shows, Russia has the lowest general government debt in the emerging markets space. The flip side however is that total investment has been low, preventing Russia from diversifying away from its energy sector.

General government debt-to-GDP ratio: major emerging economies 

% GDP

Country risk index ranking (CRI): all components

The good scoring comes mainly from low inflation, low public debt and short-term external debt, as well as a rebound in FX reserves. This is being supported by a credible commitment by the Bank of Russia to bring down inflation while supporting the economic recovery. 

Meanwhile, the private sector, both households and corporates, has substantially de-leveraged over the past years.

There is some early evidence of a broadening economic recovery in Russia, driven by new car sales, construction, labour market conditions, manufacturing sentiment, and a recovery in oil prices.

This points to solid GDP growth of 1.7% for 2017  based on our leading indicator (the grey line). However we believe this remains far below the growth potential of the Russian economy (dotted line).

Russian GDP & Leading index growth

GDP right axis / Leading Index left axis

From a structural perspective, Russia’s main drawback is the lack of reforms to rebalance the economy from dependence on energy exports towards manufacturing and services. 

We believe this will weigh on potential GDP growth in the medium to long-term. Investing in technological innovation could significantly boost Russian potential GDP growth in the long-run and should become a top priority for the government.

The main risks in the near term are geopolitical, in particular conflicts in Ukraine and Syria, and also, of course, the risk of a negative oil-price shock. 

We think Russia’s strengthening economy bodes well for domestic consumer and real estate names. 

We particularly like food retailers where forecasted profits are close to an all time high with a still-improving trend and valuations are very compelling – see chart below.  Additionally, the industry is consolidating around market leaders.

PE Ratio of Leading  food retailers in russia

Forecast earnings for next 12 months

Our proprietary leading indicator rebounded to 5.3% y/y in August, still pointing towards a pace of growth of 4.7%¹, which was actually exceeded in Q2 realised GDP growth of 4.8%.

Despite lukewarm sentiment, growth in EM industrial production has reached its highest level (5.4%) since mid-2013. Meanwhile, our aggregated EM PMI survey increased to 51.7, a level not seen since May 2011 and which is associated with an industrial production growth greater than 6%. 

EM leading indicator & GDP (left) / EM PMI & industrial production (right)