EM silver lining to DM second wave

Leveraged bets on tech are concerning, but the fact remains that this upswing is more sustainable than the previous one.

Second wave breaking. Markets have been focused on economic recovery, but the persistent risk of Covid-driven stop-start is highlighted by the rapidly rising numbers of new confirmed cases in Europe, particularly in Spain and France, but also the UK. In both the US and Europe, high-frequency mobility indicators have generally flat-lined following a strong reflex rebound in June-July. Retail sales and services led the bounce in late summer, but are now retreating once again. There is a silver lining to this gloomy picture: EMs appear to managing the pandemic increasingly effectively, while some DM sectors such as manufacturing, have remained resilient. Overall though, weakness in terms of the labour market, capex levels and external demand (for almost anything, from almost anywhere) suggest only a slow grind-up to the pre-Covid level of economic activity.

US rebound running out of steam. In the US, high-frequency indicators show that the rebound from the reopening is faltering. For instance, growth in retail sales ex autos and gas slowed to 0.7% m/m in August from a downwardly revised 1.1% gain in the previous month. This underscores the importance of employment growth and the equity market to sustain sales growth going forward. The current cycle of recovery in US stocks is more sustainable than the last one, but given the huge pressure on the real economy, we still have to accept that a “Minsky moment” will probably come before yearend.

Second wave in Europe softened by strong policy response. New Covid infections are rising at a brisk rate in the euro area, especially in Spain and France, increasing the risk of restrictions being dialled up and stopping the post-lockdown recovery in its tracks. However, national governments are rapidly extending their schemes to support the labour market and the liquidity needs of firms. For instance, Germany’s short-time work (Kurzarbeit) subsidies scheme, which was due to expire in March 2021, has been extended until the end of next year. Similarly, the bridging aid for small and medium-sized firms, which had been due to end this month, will now run until the end of this year. Meanwhile, France’s “temporary unemployment” scheme has been extended and is now expected to last up to two years. These measures minimise the pain in the immediate term although they cannot prevent job losses when firms’ liquidity needs morph into solvency concerns and bankruptcies rise amid persistent demand shortfalls.

In EM too, Markets are starting to focus on the recovery. EM have not yet beaten the virus, but death rates are nonetheless steadily declining in even the worst hit major EM economies, subject to the usual caveats around the accuracy of these statistics. We expect investor sentiment to be driven by rising economic activity despite doubts about whether government spending decisions will ultimately lead to sustainable growth. It remains the case, however, that the low level of Covid testing in many EM raises concerns about the extent to which the virus has truly been contained.

The EM recovery appears stronger than anticipated. EM governments are pushing ahead with reopening, driven by the need to prevent further economic collapse. China and Brazil are among those EM that are delivering a stronger than expected economic recovery. Importantly, we have revised upward our view of 2020 GDP growth in China, to 2.4% from 2.0% owing in part to the improving outlook for external demand. The recovery in China is, of course, an important driver for EM economies elsewhere. Indeed, China is contributing to the further pick-up in world trade volumes that is likely to favour exports from EM vs those from DM, in many cases leading to improved EM trade balances.

Europe: K-Shaped Recovery

Broad-based reflex recovery has run its course. September’s PMI data underscored the fact that the rebound in economic activity in June-July, driven by the easing of restrictions, has lost momentum. As the number of new confirmed Covid infections rises, especially in France and Spain, authorities are dialling up restrictions, which is weighing on hospitality services and damaging confidence. However, the data highlighted divergent trends within the euro area, which are likely to accelerate over the next quarters. The much-discussed K-shaped recovery is definitely visible in the data.

Services contract but manufacturing is on the mend. EA economic output stalled in September: the composite PMI fell to 50.1 from 51.9 the previous month and the recent high of 54.8 in July. (A reading above 50 indicates a sequential pickup in activity.) Activity in the services sector fell sharply: the PMI dropped to a four-month low of 47.6, down from 50.5 in August. Fears of a second wave have led to increased disruptions in consumer-facing sectors, including travel, hotels and restaurants. New orders have continued to decline while the backlog of work continues to recede, suggesting no immediate respite. However, manufacturing sector has been relatively resilient. The manufacturing PMI rose to 53.7 – its highest level since September 2018, up from 51.7 in August – driven by a large increase in new orders from domestic and external sources. The backlog of work rose, too, last month, the first such increase in two years. As the stock of purchases is falling and new orders are rising, the level of inventories is falling from the historical high in April.

The progress of the virus will decide Q4. Now that the scope and scale of government economic intervention is now a largely known quantity, it is the progress of the pandemic that is the unknown factor. Should governments get the infection rate under control, we will see stabilization (at a low level) in the services sector. Should the virus get out of control once again, manufacturing sector resilience will be tested to breaking point.

EM: The Risks of Fiscal Dominance

Inflation is low, but fiscal deficits high. For EM policymakers, the good news is that inflation is now at historically low levels in most EMs, other than Turkey. This means that the need for monetary tightening is remote for the time being, again excepting Turkey, where an ill-advised bank lending boom has forced a U-turn in policy with sharp increases in funding costs for banks. The bad news for policymakers is that the sharp rise in fiscal deficits has done little to get economies back onto a sustainable growth path. This is because fiscal erosion everywhere was partly passive, as budget revenues collapsed, and partly focused on social support rather than actual fiscal spending. China is an important outlier in this regard as it has stepped up infrastructure spending to substitute for weakness in consumer spending and external demand.

Second wave fear factor. In a world where the virus remains a worry for EM consumers, the recovery of private demand will inevitably be slow and uneven owing to the fear factor. We conclude that direct government spending needs to pick up to fill the gap left by private demand in order to sustain the recovery. How to do this when fiscal deficits are already large is the essence of the challenge facing EM policymakers.

Premature consolidation risk. Now that monetary easing is nearing an end, fiscal policy will play the dominant role in determining prospects for recovery, generating two types of risk for investors. One of them is that policy paralysis and overconfidence leads to premature attempts at fiscal consolidation. Russia provides the best example among EMs of the potential of this policy risk. Next September’s Duma election will inevitably bring with it increased government handouts, while the alternative – hiking taxes on businesses and the middle class – will result in strong headwinds to productivity gains and stronger negative multiplier effects than spending cuts. Among EMs, Russia is probably best positioned to expand government spending owing to ample FX reserves, but the government’s economic strategy appears focused on cutting the deficit. The government’s plan to launch fiscal consolidation next year is misguided.

Fiscal Dominance. The other risk facing investors is that monetary policy could be radically reoriented towards providing financing for much enlarged fiscal deficits. The situation in which the Central Bank winds up financing the government’s deficits, known in economic jargon as fiscal dominance, could come about either as a conscious policy decision or as a last resort if traditional funding sources for the deficits dried up. The dependence of individual EMs on external financing to cover their budget deficits via inflows into local rates markets or foreign bond issues varies widely. But where foreign funding is significant, fiscal dominance would act to amplify risks by triggering financing outflows.

Cautionary tale in Turkey. In many EMs, a plausible scenario might see expanded buying of government bonds by a country’s central bank, e.g. to counter rising domestic rates in order to protect economic recovery. This could, in turn, lead to outflows of foreign funds from local rates markets out of concern that inflation might start rising. Such capital outflows might lead to demands from politicians for even more such bond purchases. This scenario would sooner or later end up increasing inflationary pressures. For example, the outflow of portfolio capital from Turkey’s domestic market, totaling US$14.5bn over the past 12 months, illustrates how such outflows can destabilize domestic financial markets.

Brazil and South Africa key sites of risk. With the largest deficits to finance this year, Brazil and South Africa face the greatest challenge, but the central banks of both countries have ruled out deficit financing, at least for now. South Africa is more vulnerable than Brazil to outflows of foreign funds and for that reason presents higher risks for investors. The countries investors should probably worry about most are those which have already embarked on QE and QE-type financing programmes, i.e. Indonesia, Turkey and India.

China: On another track entirely.

The Dual circulation strategy (DCS). DCS aims to de-couple China’s economic health from the rest of the world without reverting to autarky. This means further stoking domestic demand and reducing both export dependency and reliance on external inputs in key areas, including food, technology and energy. Such “economic rebalancing” is not a new objective, however Xi’s imprimatur, Covid-19, and the deteriorating geopolitical outlook, guarantee massive political and financial firepower to revitalize formerly moribund reforms.

The near term DCS focus is de-Americanization of supply chains. Next, will come a broader, more market-led import substitution initiative. Finally, gains in consumer demand will lag trade developments, due to the politically sensitive nature of the reforms involved (hukou, pension, taxation etc.).

Winners and losers. Given the heavy reliance of some countries on Chinese demand to generate growth, any change in PRC import patterns is liable to generate big cascading effects for exporters. Asia is most exposed, the EA is just behind with Germany much more exposed to China demand than Italy or Spain. As Chinese sectors and supply chains detach (in some cases forcibly) from the US, the EA and North Asian high-tech manufacturing sector stands to win market share. In particular, we expect, Korea, Taiwan and Japan to benefit from acute PRC vulnerability to semiconductor sanctions. The technological complexity of the industry also provides a wide moat to protect from China movement up the chip value chain.

EA exports as a whole are at risk. Sales of machinery to China account for more than one-third of total EA exports there. Adding export of vehicles and parts, accounting for 16%, we get to half of all export flows from the EA to China. German and Italian export baskets are the most skewed towards capital goods. Similarly, other transport equipment (ships, aircrafts and trains) is the key export sector for France. But in Spain – where China accounts for 0.85%/GDP of VA, exports are dominated by intermediate goods and commodities. On a relative basis and especially on an intra-euro-area basis Spain may well be a winner from dual circulation.

An opportunity to expand into China’s “mega-market” for consumer goods? Consumer goods (food, cars, clothing etc.) are also an important component of the EA export basket to China. And as Beijing’s efforts to stoke domestic demand will likely increase the imports of consumables, EA firms should seize the opportunity. China is already the largest market for most EA consumer goods producers and European multinationals derive a huge share of revenues from what Xi Jinping calls China's "mega-market".

Further economy/stock market decoupling. Finally, a by-product of China's DCS could be to increase the divergence between the real economy and mega-cap stocks. Large firms that can directly exploit the Chinese market will optimize their supply chain in the Mainland to satisfy DCS constraints and deal with the tougher international trade environment, ultimately supporting earnings as the Chinese market grows. Smaller firms might find this costlier and harder to accomplish. Moreover, such optimization could happen at the expenses of the domestic supply chain. For example, in Europe this would deal a new blow to those SMEs that form the backbone of the EA manufacturing base and that have already been losing out from globalization, posing not only economic (job losses) but also significant political (increased inequality) challenges going forward.

Disclaimer: The views expressed above are based on research and should not be relied upon on a standalone basis for any investment decision making.