Download emerging markets: Improved Cyclical trends After a Long

leadership series
september 2016
business cycle update
Emerging Markets: Improved Cyclical
Trends After a Long Dry Spell
Better economic conditions offer a more favorable near-term outlook for growth
and equities after cyclical downturn
Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research
Lisa Emsbo-Mattingly l Director of Asset Allocation Research
Cait Dourney l Analyst, Asset Allocation Research
Joshua Lund-Wilde, CFA l Research Analyst, Asset Allocation Research
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THIS ISSUE
KEY TAKEAWAYS
• Global economic stabilization, including a
steadier China, has caused some cyclical
headwinds to recede and improved the nearterm prospects for many emerging-market
(EM) countries.
Manufacturing activity and raw industrial prices have
rebounded
page #2
China’s fiscal stimulus key to EM outlook
page #3
• With the recession ending in global trade,
manufacturing activity, and commodity prices,
the EM business cycle and corporate earnings
outlooks have become more favorable.
EM corporate earnings appear to have bottomed
•The recent fundamental improvements in EMs—
especially relative to low market expectations—
support our more positive view on EM equities.
page #5
•The U.S. economy continues to experience a
mix of mid- and late-cycle dynamics with low
odds of recession.
• We continue to favor global equities and
inflation-resistant assets, though smaller asset
allocation tilts may be warranted.
page #4
Despite Brexit, Euro Area economy remains in
mid-cycle expansion
Brazil enters early-cycle recovery
page #6
Asset allocation implications
page #6
Business Cycle Framework
page #7
Fidelity’s Asset Allocation Research Team employs a
multi–time-horizon asset allocation approach that analyzes
trends among three temporal segments: tactical (short term),
business cycle (medium term), and secular (long term). This
monthly report focuses primarily on the intermediate-term
fluctuations in the business cycle, and the influence those
changes could have on the outlook for various asset classes.
leadership series
september 2 016
For the better part of the past five years, we have highlighted
the cyclical challenges facing emerging market (EM) economies as a group. As expected, emerging-market equities
lagged those of the U.S. and other developed markets during
this period. However, recent improvements in the global
economy and EM business cycle trajectories have caused
some cyclical headwinds to recede and the near-term prospects for many of these countries to improve.
Lingering challenges after a cyclical boom
The big story in EMs during the past few years has been the
downshifting from rapid growth to a more moderate pace.
While the emerging-market category contains a wide variety
of countries, there are a handful of common challenges that
have defined this period and came to a head during 2015:
•The end of China’s boom—China is not only the largest
emerging market but also the biggest external influence
on the economic performance of many other EMs. In
recent years, China’s thriving economic growth gave way
to a credit-fueled investment boom that left it burdened
with massive private leverage, severe imbalances, and
overcapacity in the industrial and property sectors.
•Global trade and industrial recession—The ripple
effects of China’s slowdown—both the excess capacity in its industrial sector as well as the drop in import
demand—were the biggest contributors to the global
trade recession in 2015. This downturn was defined by
weak manufacturing and plummeting commodity prices
(see Exhibit 1). The effects have been felt most acutely in
emerging-market countries, many of which are commodity producers or have close trade linkages with China.
•Financial pressures—As a result of these and other
economic challenges, many EMs faced tighter credit
and monetary conditions. Countries such as Russia and
Brazil experienced steep declines in the values of their
currencies and were forced to hike interest rates to arrest
the rise in inflation. The Fed’s move to a rate-tightening
cycle put additional pressure on global liquidity.
Exhibit 1 Commodity Prices vs. Manufacturing Activity
After bottoming in late 2015, manufacturing activity and
commodity prices have rebounded
Exhibit 2 China Fixed Asset Investment
Public spending on fixed assets has risen in China
during 2016, while private investment has stalled
12-Month Change
40%
Change (Year-Over-Year)
45%
EM manufacturing diffusion index
30%
80%
20%
70%
10%
60%
0%
50%
–10%
Raw industrials prices
30%
Jul-2012
Sep-2012
Nov-2012
Jan-2013
Mar-2013
May-2013
Jul-2013
Sep-2013
Nov-2013
Jan-2014
Mar-2014
May-2014
Jul-2014
Sep-2014
Nov-2014
Jan-2015
Mar-2015
May-2015
Jul-2015
Sep-2015
Nov-2015
Jan-2016
Mar-2016
May-2016
Jul-2016
–20%
40%
Source: Commodity Research Bureau, Markit, Haver Analytics, Fidelity
Investments (AART), as of Jul. 31, 2016.
2
40%
35%
Private
30%
25%
20%
15%
Public
10%
5%
0%
Jan-2011
Apr-2011
Jul-2011
Oct-2011
Jan-2012
Apr-2012
Jul-2012
Oct-2012
Jan-2013
Apr-2013
Jul-2013
Oct-2013
Jan-2014
Apr-2014
Jul-2014
Oct-2014
Jan-2015
Apr-2015
Jul-2015
Oct-2015
Jan-2016
Apr-2016
Jul-2016
Share of PMIs > 50 (3M Avg)
90%
Source: NBS, Haver, Fidelity Investments (AART), as of Jul. 31, 2016.
business cycle update: Emerging Markets: Outlook Improves FOR ECONOMY AND STO CKS
Global stabilization, base effect support EMs in near-term
While some of these challenges have by no means disappeared, the near-term cyclical outlook has improved materially for EMs as a group. As we highlighted nine months ago
in our 2016 outlook (see Leadership series article “Global
Environment Poised to Stabilize as 2016 Progresses”), global
stabilization in 2016 would provide the backdrop to end the
sharp declines in emerging-market economies, commodity
prices, and EM currencies. We believe the following cyclical
changes are beginning to take shape as we projected:
• China’s stabilization—After a volatile 2015, policymakers
in China have demonstrated a commitment to near-term
stability, and have implemented substantial fiscal stimulus measures in order to support real activity (see Macro
Update: China).
• Positive “base effect” of global stabilization—Steadiness in China has contributed to a reacceleration in
global manufacturing activity, a firming in global trade
activity, and a rebound in commodity prices (Exhibit 1).
While these trends do not imply a rapid reacceleration
Exhibit 3 Real GDP Growth Forecasts, 2016-2035
EM countries are likely to grow faster than developed
markets over the next 20 years
Annualized Rate (%)
6
5
Emerging Markets
4
3
2
Developed Markets
1
Italy
Japan
Spain
Netherlands
Germany
France
Canada
Australia
Sweden
U.K.*
U.S.
South Korea
Russia
Thailand
Turkey
Brazil
Mexico
South Africa
Colombia
Peru
Malaysia
China
Indonesia
Philippines
India
0
* U.K. growth estimate may vary based on Brexit implications. Average
forecasts are GDP weighted. GDP: gross domestic product. Source: Fidelity
Investments (AART), as of Dec. 31, 2015.
back to boom times, they benefit from the ability to grow
off a very low base.
•Improved cyclical outlooks in many EMs—Many EMs
are now receiving support from a similar base effect.
After settling at a lower level, there now exists an opportunity for an upside surprise for some countries in
economic activity and corporate earnings growth. For
example, after falling to a multi-year low in late 2015,
our diffusion index of EM manufacturing activity has
rebounded significantly over the past 10 months (Exhibit
1). Raw industrial prices have risen into positive territory
on a year-over-year basis for the first time in more than
two years. After corporate earnings declines of nearly
20% in 2015, growth is no longer deteriorating and
expectations appear to have inflected positively.
•Easier financial conditions—The more-gradual-than-expected pace of Fed tightening in 2016, as well as additional global easing after June’s Brexit referendum, has
allowed EMs to enjoy more favorable liquidity conditions.
The recent rally in EM debt instruments has pushed
yields down close to historically low levels, lowering the
borrowing cost for EM sovereigns and many corporates.
Cyclical risks
While financial market turbulence can always rear its head,
the principal risk to our positive near-term outlook for EMs
is China. China’s stabilization has been heavily dependent
on policy action, as demonstrated by the rise in government spending on fixed asset investment (FAI) alongside
the decline in private-sector FAI (see Exhibit 2). Ultimately,
China will need to enact structural reforms to clear out the
excessive credit and industrial capacity, which will likely entail
higher economic and financial risks. Similarly, we do not
expect emerging markets as a group to experience a robust,
early-cycle type reacceleration anytime soon. Many EMs
share cyclical and structural challenges such as a credit overhang and overcapacity, and still face a long-term adjustment
to a slower growing global economy.
Strong secular prospects for emerging markets
Beyond the cyclical outlook, we believe EMs have relatively
positive secular growth prospects (see Leadership Series
article “Secular Outlook for Global Growth: 2016-2035”). We
3
leadership series
september 2 016
expect that over the next 20 years, emerging-market countries will grow faster than developed markets (see Exhibit
3), in large part due to faster labor force growth. In addition, several EMs with youthful demographics—such as the
Philippines, India, and Indonesia—also have the benefit of
considerable “catch-up potential” to grow productivity rates
off a relatively low base. The largest risk to this relatively rosy
secular outlook is the potential for financial instability, particularly in China. Historically, growth-destroying financial crises
most often occur after a large build-up of imbalances, and
financial fragility is most pronounced in China and in EM Asia.
Asset allocation implication: Positive cyclical outlook for
EM equities
Our business cycle framework is founded on the principle
that in the near and intermediate term, asset prices are
influenced more by the change in the rate of growth rather
than the level of growth itself. In other words, over the next
12 months any improvement in cyclical trends in EMs is likely
to outweigh investor concerns about the diminished pace of
Exhibit 4 Emerging Market Earnings Growth
The profit outlook has improved for EMs, with earnings
growth turning positive in some countries
Growth (12-Month Trailing)
60%
Emerging Markets
Brazil
India Mexico
40%
20%
0%
–20%
–40%
Jun-2011
Sep-2011
Dec-2011
Mar-2012
Jun-2012
Sep-2012
Dec-2012
Mar-2013
Jun-2013
Sep-2013
Dec-2013
Mar-2014
Jun-2014
Sep-2014
Dec-2014
Mar-2015
Jun-2015
Sep-2015
Dec-2015
Mar-2016
Jun-2016
–60%
Source: MSCI, FactSet, Fidelity Investments (AART), as of Jul. 31, 2016.
4
absolute growth relative to the prior global boom period. As
a result, the fundamental improvements we are observing—
especially relative to low market expectations—have made us
more positive on EM equities during the course of 2016 than
at any point during the past few years. Positive drivers for EM
equities include:
•U.S. business cycle outlook: Historically, EM equities
perform well on a relative basis during the U.S. late cycle,
partially due to commodity-exporters benefiting from
a pickup in inflation and rising commodity prices (see
Macro Update: U.S.).
•EM business cycle fundamentals: The corporate
earnings outlook has improved, with profit growth trends
improving and turning positive in countries such as
Brazil, India, and Mexico (see Exhibit 4). According to
our business cycle models, China has stabilized, Brazil
has entered early cycle, and India’s mid-cycle expansion
continues (see Macro Update: Global).
•Foreign Exchange (FX): Our analysis indicates that many
EM currencies are either at fair value or undervalued relative to the dollar, and we anticipate that FX will no longer
be a headwind for USD-based investors in the near term.
•Secular drivers: Over the long term, strong growth prospects and more attractive valuations relative to developed
markets make EM equities a key component of a global
equity portfolio.
business cycle update: Emerging Markets: Outlook Improves FOR ECONOMY AND STO CKS
Business Cycle: Macro Update
The U.S. and global economies have continued to gain
momentum despite post-Brexit headwinds. The U.S. continues to
experience a mix of mid- and late-cycle dynamics with low odds
of recession, while the global economic expansion continues at a
slow but steady pace.
United States: Late-cycle indicators elevated, recession odds
remain low
Consumer supports continued expansion
Favorable employment conditions have helped soak up a
significant amount of excess slack in the labor markets.
Hiring remained solid in July, although the pace of gains has
decelerated—as is consistent with historical late-cycle dynamics.
Wage pressures remain in an uptrend and continue to support
consumer spending, particularly for housing.1 Both core and
headline inflation measures are poised to end 2016 above 2%, as
the uptrend in wages is keeping core inflation measures firm while
oil prices will soon begin to lap late 2015’s subdued levels. Tight
labor markets and rising income suggest that the U.S. consumer
is providing a solid foundation for continued U.S. expansion.
Mixed outlook for business sector
Stabilizing external conditions have helped the U.S. business
sector regain footing from the recent slowdown. The
reacceleration in industrial activity, as well as fewer headwinds
from oil prices and the dollar, suggests an opportunity for earnings
to surprise to the upside in the near term. In fact, second quarter
S&P 500 earnings appear to have risen for a second consecutive
quarter in Q2—the first time since mid-2014.2 Late-cycle trends
continue to build, however, with banks further tightening lending
standards for businesses.3 Moreover, rising wage pressures are
likely to begin weighing more heavily on corporate profit margins.
The corporate sector is experiencing a modest upswing, but
late-cycle trends are likely to cap the upside.
Global: Stabilization continues despite Brexit risk
U.K. recession risk elevated post-Brexit
Brexit increased the risk of recession in the U.K, although so
far the impact on real economic activity has appeared limited.
Business investment expectations and consumer confidence
turned sharply lower in the weeks after the referendum, but
consumers remain resilient amid a healthy jobs market, and the
policy response from the Bank of England could hold off a sharp
contraction. Political uncertainty from the Brexit aftermath
remains a headwind for business investment, but the household
sector is underpinning the UK’s late-cycle expansion.
Europe: Expansion on track despite Brexit headwinds
The Euro Area remains in a mid-cycle expansion phase, benefiting
from a stronger manufacturing sector and improving credit
conditions. The French consumer sector appears buoyant; easing
German mortgage conditions signal a potential reacceleration in
construction; and the probability of recession in Italy has declined
alongside concerns about its undercapitalized banking system.
European economic sentiment indicators have, so far, been
little changed following the Brexit vote (see Exhibit A). Europe’s
domestic economy appears strong enough to continue its tepid
cyclical expansion despite rising political uncertainty.
China stabilizing amid fiscal response
A downshift in growth at the end of an overextended credit boom
has caused China to remain in a growth recession for the past
Exhibit A Euro Area Economic Sentiment
Economic sentiment in the Euro Area remains steady
post Brexit
Long-term Average = 100
120
110
100
90
80
70
3 Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART),
as of Aug. 1, 2016.
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2 Source: Standard & Poor’s, Fidelity Investments (AART), as of Aug. 11,
2016.
60
2005
1 Source: Bureau of Economic Analysis, Haver Analytics, Fidelity
Investments (AART), as of Jun. 30, 2016.
Source: European Commission, Haver Analytics, Fidelity Investments
(AART), as of Jul. 31, 2016.
5
leadership series
september 2 016
year, but the economy has steadied during the past several
months. Recent economic stabilization can largely be attributed
to a strong fiscal policy response that has supported the industrial
and property sectors. After declining for the past four years,
producer prices have started to flatten, signaling the worst of the
deflationary phase could be passing. China appears to be nearing
the end of a growth recession, but greater structural reforms
will likely be needed for a sustainable reacceleration.
beneficiary of lower commodity prices, India’s economy was
able to weather the global slowdown of 2015 better than many
emerging-market economies. India is in a modest mid-cycle
expansion, helped by steady improvement in its industrial and
consumer sectors. Monetary easing from 2015 is beginning to
have a positive lagged impact on credit conditions. Economic
growth remains relatively high and stable, but does not appear
to be in a position to accelerate meaningfully.
Brazil entering an early-cycle recovery
Brazil is showing signs of exiting one of the most painful
recessions in its history. While sentiment indicators remain at
relatively low levels, their sharp improvement in recent months is
a classic sign of an early-cycle recovery. Inflationary pressures
have recently decelerated, although year-over-year price growth
of 9% is keeping the central bank from cutting rates from a stillrestrictive level of 14.25%. Recession probability indicators have
declined sharply, but lower inflation and a shift toward monetary
easing are likely needed to generate a sharp acceleration in
growth.
Global summary: Stabilization continues
Most post-Brexit data show the global economy continues to
modestly reaccelerate across a variety of metrics. Roughly 70%
of countries’ manufacturing bullwhips—leading indicators for
manufacturing activity—were in expansionary territory in July.
Japan has begun to recover from a mild recession, underpinned
by improvements in the consumer sector. Policymakers
announced a large stimulus package in July, but the size of the
impact remains to be seen. Commodity-exporting countries such
as Canada and Australia—as well as major China trading partner
South Korea—remain in late-cycle expansions and continue to
improve incrementally alongside China’s stability. The tepid global
economy continues to gain cyclical traction.
India: High relative growth with improvements on the margin
With limited exposure to Chinese trade demand and as a net
Outlook/asset allocation implications
The post-Brexit spike in market volatility has been followed by
several weeks of summer calm. The shift to a more accommodative monetary stance by major central banks likely
played a large role in this turnaround. However, the resilience
of the global economy in the face of another headwind has
probably also been a factor, and incremental signs of global
stabilization continue to build. These trends are particularly
noticeable among many of the EM economies, even if a
return to vibrant growth is likely to remain elusive.
6
Consistent with our business cycle view that asset prices
tend to respond to cyclical improvement, we continue to favor
global equities. In particular, EM equities still enjoy the benefit of low growth expectations and relatively attractive valuations. The rising probability of a U.S. shift into the late-cycle
phase suggests market volatility could return and that smaller
cyclical asset allocation tilts may be warranted at this phase
of the cycle. A move toward late-cycle dynamics would also
tend to favor assets that benefit or are more resistant to
inflation, including EM and energy-sector equities, TIPS, and
shorter-duration bonds.
business cycle update: Emerging Markets: OUTLOOK IMPROVES FOR ECONOMY AND STO CKS
Business Cycle Framework
The world’s largest economies are in various phases of the business cycle.
Cycle Phases
EARLY
MID
LATE
RECESSION
• Activity rebounds (GDP, IP,
employment, incomes)
• Growth peaking
• Growth moderating
• Falling activity
• Credit growth strong
• Credit tightens
• Credit dries up
• Credit begins to grow
• Profit growth peaks
• Earnings under pressure
• Profits decline
• Profits grow rapidly
• Policy neutral
• Policy contractionary
• Policy eases
• Policy still stimulative
•Inventories, sales grow;
equilibrium reached
• Inventories grow; sales
growth falls
• Inventories, sales fall
• Inventories low; sales improve
Inflationary Pressures
Red = High
Germany
India
Brazil*
Italy and
France
Australia
Canada
U.S.
South
Korea
+
Economic Growth
–
RECOVERY
CONTRACTION
China*
and Japan
EXPANSION
U.K.
Relative Performance of
Economically Sensitive Assets
Green = Strong
Note: The diagram above is a hypothetical illustration of the business cycle. There is not always a chronological, linear progression among the phases of the
business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. *A growth recession is a significant decline in
activity relative to a country’s long-term economic potential. We have adopted the “growth cycle” definition for most developing economies, such as China,
because they tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend
tends to matter the most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed
economies. Please see endnotes for a complete discussion. Source: Fidelity Investments (AART).
Authors
Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research
Cait Dourney l Analyst, Asset Allocation Research Lisa Emsbo-Mattingly l Director of Asset Allocation Research
Joshua Lund-Wilde, CFA l Research Analyst, Asset Allocation Research
The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation
recommendations for Fidelity’s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment
perspectives across Fidelity’s asset management unit to generate insights on macroeconomic and financial market trends and their
implications for asset allocation.
Asset Allocation Research Team (AART) Senior Analysts Austin Litvak and Jacob Weinstein, CFA, and Research Analyst Jordan Alexiev also
contributed to this article. Fidelity Thought Leadership Vice President Kevin Lavelle provided editorial direction.
7
leadership series
september 2 016
© 2016 FMR LLC. All rights reserved.
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Information presented herein is for discussion and illustrative purposes
only and is not a recommendation or an offer or solicitation to buy or sell
any securities. Views expressed are as of the date indicated, based on the
informa­tion available at that time, and may change based on market or
other conditions. Unless otherwise noted, the opinions provided are those of
the authors and not necessarily those of Fidelity Investments or its affiliates.
Fidelity does not assume any duty to update any of the information.
During the typical mid-cycle phase, the economy exits recovery and
enters into expansion, characterized by broader and more self-sustaining
economic momentum but a more moderate pace of growth. Inflationary
pressures typically begin to rise, monetary policy becomes tighter, and
the yield curve experiences some flattening. Economically sensitive asset
classes tend to continue benefiting from a growing economy, but their
relative advantage narrows.
Investment decisions should be based on an individual’s own goals, time
horizon, and tolerance for risk. Nothing in this content should be considered
to be legal or tax advice, and you are encouraged to consult your own
lawyer, accountant, or other advisor before making any financial decision.
During the typical late-cycle phase, the economic expansion matures,
inflationary pressures continue to rise, and the yield curve may eventually
become flat or inverted. Eventually, the economy contracts and enters
recession, with monetary policy shifting from tightening to easing. Less
economically sensitive asset categories tend to hold up better, particularly
right before and upon entering recession.
Fixed-income securities carry inflation, credit, and default risks for both
issuers and counterparties.
Although bonds generally present less short-term risk and volatility than
stocks, bonds do contain interest rate risk (as interest rates rise, bond
prices usually fall, and vice versa) and the risk of default, or the risk that an
issuer will be unable to make income or principal payments. Additionally,
bonds and short-term investments entail greater inflation risk—or the risk
that the return of an investment will not keep up with increases in the prices
of goods and services—than stocks. Increases in real interest rates can
cause the price of inflation-protected debt securities to decrease.
Stock markets, especially non-U.S. markets, are volatile and can decline
significantly in response to adverse issuer, political, regulatory, market, or
economic developments. Foreign securities are subject to interest rate,
currency exchange rate, economic, and political risks, all of which are
magnified in emerging markets.
Investing involves risk, including risk of loss.
Past performance is no guarantee of future results.
Diversification and asset allocation do not ensure a profit or guarantee
against loss.
All indices are unmanaged. You cannot invest directly in an index.
Increases in real interest rates can cause the price of inflation-protected
debt securities to decrease.
The commodities industries can be significantly affected by commodity
prices, world events, import controls, worldwide competition, government
regulations, and economic conditions.
The Business Cycle Framework depicts the general pattern of economic
cycles throughout history, though each cycle is different; specific
commentary on the current stage is provided in the main body of the text.
In general, the typical business cycle demonstrates the following:
During the typical early-cycle phase, the economy bottoms out and picks
up steam until it exits recession then begins the recovery as activity
accelerates. Inflationary pressures are typically low, monetary policy is
accommodative, and the yield curve is steep. Economically sensitive asset
classes such as stocks tend to experience their best performance of the
cycle.
8
Index definitions
A Purchasing Managers’ Index (PMI) is a survey of purchasing managers
in a certain economic sector. A PMI over 50 represents expansion of
the sector compared to the previous month, while a reading under 50
represents a contraction, and a reading of 50 indicates no change. The
Institute for Supply Management® reports the U.S. manufacturing PMI®.
Markit compiles non-U.S. PMIs.
The Consumer Price Index (CPI) is a monthly inflation indicator that
measures the change in the cost of a fixed basket of products and services,
including housing, electricity, food, and transportation.
The S&P 500 ® Index is a market capitalization-weighted index of 500
common stocks chosen for market size, liquidity, and industry group
representation to represent U.S. equity performance. S&P 500 is a
registered service mark of The McGraw-Hill Companies, Inc., and has been
licensed for use by Fidelity Distributors Corporation and its affiliates.
Third-party marks are the property of their respective owners; all other
marks are the property of FMR LLC.
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