In a prescient report called “Crumbling BRICs,” Neil Shearing of Capital Economics laid out his vision of doom for the major emerging markets. Three years on, the bear has turned. Even the prospect of sustained US interest rate hikes can’t shake Shearing’s newfound optimism. As part of our Expert Q&A series, Shearing tells Frontera’s Managing Editor Gavin Serkin why that is.
Neil: We’d been at the very bearish end of the spectrum for a long while – and then, suddenly, everyone was very very bearish. I think what changed the mood was the collapse of the Chinese stock market. But really this told us absolutely nothing about what’s happening in the Chinese economy.
China’s economy itself seems to be doing quite well, conditions have been relatively stable over the past 12 months or so. Although growth is much weaker than official GDP figures suggest, people accept that now. And we’ve got policy stimulus in the pipeline, economic output is starting to accelerate, and I think the next 12 months is going to be characterized by more upside surprises than downside surprises.
Gavin: So upside surprises from China; what about the rest of the emerging markets?
Neil: Particularly in China – but in the EM world generally, because if China stabilizes and recovers, then commodity prices probably pick up a bit further from here, and that helps Latin America, that helps Africa. So I think we’re on the cusp.
Gavin: Even with the Fed?
Neil: There are clearly risks out there. One is the Fed, but I think even there we need to move away from this idea of viewing the emerging world as one homogeneous entity. At Capital Economics, we cover nearly 70 EMs, all very different – some are energy exporters, some are energy importers, some have big current account deficits, some have surpluses, some are manufacturers, some make commodities – you need to differentiate.
When it comes to the Fed, the important thing is, to what extent are you dependent on foreign financing? Do you have a big current account deficit? Turkey does, South Africa does – I’m worried about them.
But it’s not going to be an issue for most of Asia, where there are surpluses. It’s not going to be an issue for countries like Mexico, or indeed central Europe, where they’re tied more to the ECB. So I think we really need to stop thinking about the Fed raising interest rates as a calamity for the emerging market world, and start thinking about which EMs are most vulnerable to that, price those markets accordingly, and try and pick the ones that are less vulnerable.
Gavin: But thinking about the vulnerable – what about China? Because that’s been a debt situation that a lot of people have been worried about. Doesn’t the Fed play into that? Won’t we suddenly become much more aware of just how much debt China has got when borrowing costs really start rising?
Neil: It’s possible that the Fed raising rates crystallizes some concerns about debt levels in EMs. But I would emphasize two things:
One is that – again – this is not widespread. It’s concentrated to a handful of – albeit very large economies – China, Brazil, Turkey. They’re the ones I’d really worry about. But, secondly, it’s all local debt, it’s not foreign debt – particularly in China’s case, but also in Brazil. So it’s difficult to see how an increase in US interest rates really affects the cost of local currency debt in those countries.
What’s really going to influence debt levels and how they pan out, is what happens in local policy. And in Brazil’s case, the debt problem seems to be unwinding already.
In China’s case it’s inflating further, and that’s going to support growth over the next 12 months. The issue then is how does this debt problem play out?I think that’s an issue for a couple of years further down the line. We’ll kick the can a bit further down that road. But that’s going to be the issue – how does Beijing deal with this?
Gavin: And what’s the outlook for the yuan? The Chinese currency is moving from tracking the dollar to more of a basket, so how does that play into the outlook?
Neil: This is absolutely critical. We should start to understand that China is moving away from managing its currency against the dollar, to instead tracking the currency against a basket. And that’s going to have some important implications, particularly if we’re right in thinking that the Fed is going to raise interest in the second half of this year – the dollar starts to strengthen against the euro, and the yen as a result.
If they’re managing the renminbi against the basket, then that means the renminbi weakens against the dollar, just as we come to the US Presidential elections in November. So that could be a flash point. It doesn’t mean a devaluation by China, because they keeping a level trading rate. But it does mean the currency starts to weaken against the dollar because the dollar is globally very strong.
Gavin: So, overall you’re pretty optimistic for emerging markets, but where would you look to invest in particular?
Neil: So I think it really comes down to whether you view the glass as half full– which would be the view that this is a recovery where a lot has already been priced in, particularly for commodity markets – or the glass is half empty, which would be based on a view that structurally the trend growth in emerging markets is much slower, and there are these big imbalances: high debt levels in China and Brazil, over-investment in China, too little investment in Brazil and Russia, and so on. These are the big questions that are going to shape the outlook for the next five years.
In the short term, as that economic recovery continues, most EM equities should perform quite well – perhaps a lot of the good news is priced into the Brazilian equity market now, but manufacturing-based EMs I think will do quite well, and consumer focused equities should do quite well too.
Gavin: And in terms of countries, which would be your top picks?
Neil: Countries like Mexico – particularly places where the domestic economy is in really good shape. In parts of Southeast Asia there are good-news stories too, and even in places like Russia and Brazil, the outlook is pretty grim, but I think the recessions will start to ease by the end of this year.
Gavin: And the places you’ve been concerned about would be the likes of Brazil and perhaps Turkey, based on what you’ve been saying about debt levels?
Neil: Yes, Turkey and South Africa. In Turkey’s case, debt levels; in South Africa’s case, external vulnerabilities, in particular to rising US interest rates. In China, there’s a medium-term issue about debt levels too. In Brazil, frankly, how the politics plays out is anyone’s guess. But the assumption in markets is that changing governments will bring more market friendly policies. I think that’s possible in the short term, but how well that sticks is up for debate.