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The recent emerging market boom has commentators in a buzz. And while many see this narrative as inevitable, Drikus Combrinck argues otherwise. He says that while the current framework points to an ‘out of the woods’ recovery, it was driven by structural forces which are now exhausted or set to reverse. Some good analysis. – Stuart Lowman
By Drikus Combrinck*
The JSE has had quite a rally since the lows of January and so has the Rand. In fact, the iShares South Africa ETF listed on the NYSE has bounced more than 40% off its lows.
The turnaround can largely be explained by the more dovish stance the US Federal Reserve took with regards to interest rates. The immediate impact was an end to the dollar rally which loosened the grip of a strong dollar on commodity prices.
The prolonging of a a low interest rate environment also meant carry-trade reversals stopped and a search for yield took hold again which saw emerging markets (EM) benefit.
Meanwhile, China implemented a spending package and continued to support credit extension, which saw a much needed uptick in the physical demand for industrial commodities. Locally, our beleaguered Finance Minister managed to calm market participants by keeping fiscal spending in check and making a visit to a couple of SA’s biggest financiers.
At this stage one is tempted to think that the cycle has turned. Investors are once again piling funds into risk assets and market commentators have started to announce the end to the EM-rout. Structural forces would however suggest otherwise:
Commodities
Commodities traded in a bubble pre-Lehman and recovered most of its lost ground due to record low interest rates and unprecedented fiscal spending by the Chinese. It is quite right for commodities to experience weakness if those two factors should change. Going by previous supply gluts, like the rail-road industry in the 1870’s, it takes many years if not decades for the industry to regain its pricing power.
We should have been 8 years in already, but low interest rates and the Chinese response have created a disincentive for commodity producers to disinvest and deleverage. As a result, the cycle is only about in its third year and still lacks serious supply side response.
Yield curve
Low inflation in the US has allowed the FED to delay tightening. Most of the weakness in inflation is due to lower oil prices and a stronger Dollar. Inflation will most likely make a comeback in the second half of 2016 as the base effects of low oil prices and the dollar kick-in.
The labour market is in good shape and only has a little slack left before having a profound effect on unit-labour cost. According to Taylor’s rule (the standard guideline for interest rate setting) the US Fed Funds rate should be about 2% higher than the present 0.5%. We would contend that the risks to a yield curve move is asymmetrical at present.
Markets are unprepared for a rise in longer-term interest rates as they have been massaged into a condition of complacency by central banks. The longer this condition persists the longer a skewed incentive system perpetuates the growing vulnerabilities of certain asset prices and economies.
Emerging markets
In particular, low interest rates have provided easy money to emerging market governments and their consumers. The level of total debt has however grown to alarming levels. Just as the credit boom supported EM assets and currencies in the boom years, so it will be a drag to EM assets and currencies going forward.
A lot of EM political leaders have also grown complacent during the boom years and serious structural adjustments to policies are necessary. Many EM countries will however only make such adjustments after much more social, economic and political pain is felt. Those who are unable or unwilling will get caught in the so called “Middle-Income Trap”.
China
Growth in EM hinges on China’s continued success. China’s economy is notoriously unbalanced and for that reason rapid reforms may cause a fall-off in investment spending big enough for a complete collapse in demand. Reforming too slowly is the more probable risk, which will result in an ever slowing Chinese economy.
China’s main response is to throw more credit at the problem. Nominal GDP is growing at 6.7% presently, while credit growth is above 15%. There is however little room to manoeuvre as China’s total credit-to-GDP has reached 250% and now represents a systemic risk.
South Africa
On the face of it, it looks like SA is in a stagflationary bind similar to the 1980’s. That is, high inflation and below trend growth. This may be due to transitory forces which will untangle as time goes by.
However, stagflation is also a consistent manifestation of the Middle-income trap. The jury is still out on which it will be, and much depend on the political economy.
To elude the Middle-income trap deep structural reforms are needed, but that is highly unlikely given our current political climate.
Numerous market participants still believe the narrative that the economic ascendancy of EM is inevitable. From that framework one should be inclined to think that we are indeed “out of the woods”. However, the EM boom that we experienced was primarily driven by structural forces which are now exhausted or set to reverse. The narrative has changed. We are not in Kansas anymore.
• Drikus Combrinck is Founder and CEO of Capicraft Investment Partners
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