BNP: Emerging Markets readying for the next great race

Emerging market equities have underperformed developed market equities for more than three years; do you think it will be different in 2015?

Global emerging market equities’ underperformance relative to that of developed markets started in late 2010 and was almost coincidental with a pronounced slowdown in world GDP growth, triggered mainly by the Eurozone debt crisis and a simultaneous slide in commodity prices.

We believe today that global growth, essentially led by the US, will gradually strengthen towards potential in 2015 and beyond. Moreover, while in our view there will be no outright defl ation at global, regional or country level, prolonged low infl ation is likely to be widespread. And while we do not see global liquidity rising any further, it should remain ample as both Japan and the Eurozone compensate for the end of US-led quantitative easing (QE). Against this background, equities as an asset class should do reasonably well. In fact as long as the world avoids recession, it is hard to imagine a prolonged bear market especially with cash yielding historically little and with earnings growth being positive.

Emerging market equities should outperform relative to their developed counterparts as their valuation discount to the latter is bigger than it should be, in our view. Most emerging markets are today structurally sounder than they were before the Global Financial Crisis, with most of them having, for example, improved their credit rating. So it is not unreasonable to ask whether the valuation discount for many of them remains justifi ed. 

Equally, we do not foresee any meaningful rise in bond yields at a global level. That said, in the short term, bonds should do quite well as risk aversion is likely to remain high during the “cautious” transition phase from “super soft” to “normal” US monetary policy. However, given the current low yield on sovereign bonds and the tight spreads on corporate bonds and credit, the return potential of fixed income assets looks limited to us.

China, which accounts for the lion’s share of emerging market equity market capitalisation, is facing slower growth, and there is no sign that this will change in the coming years. Does this not make you cautious on Chinese and thus emerging market equities? 

The growth slowdown in China is largely being engineered and seems to be well under control. In fact when the new Chinese government set up its ambitious reform programme in November 2013, they clearly understood that its implementation would entail softer growth. After all, you can’t have all your turbines running at full tilt while you reallocate resources from low to higher valueadded sectors at the same time as; a) engineering a transition to a more market-oriented growth model; b) reshaping the fi scal landscape and; c) progressively opening the capital account. We have no doubt that these reforms, which are generally on schedule, will have a very positive long-lasting impact on Chinese government spending, financial stability and economic sustainability. One should also take into account that, at around 7% YoY, Chinese GDP growth is close to if not actually at its current potential. It is also contributing proportionately more to world growth than it was ten years ago when it was growing at more than 10% annually in real terms.

There is thus no reason to be pessimistic on Chinese equities, although as for all other equity markets they will never move up linearly. Moreover, should growth show signs of slowing too muchbelow expectations, i.e. the targeted growth rate, the government would certainly continue to accompany “targeted stimulus measures” with broader action, in the form of a reduction in benchmark interest rates possibly combined with renewed fiscal stimulus.

Also worth mentioning are a savings rate of 40% and foreignexchange reserves totalling USD 4 trillion, which give the Chinese government the financial firepower to counter most growth or financial stability problems such as the slowdown in real estate and the correlated increase in non-performing loans. 

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