Emerging markets to diverge as U.S. thrives, China slows, Europe lags

LONDON - Investors are rethinking their exposure to emerging markets, focusing on countries likely to weather lean times with manufacturing exports to the United States while avoiding those that have thrived on sending commodities to a now slowing China.

After the financial crisis erupted in 2008, emerging markets drew in huge amounts of capital as investors fled ultra-low interest rates brought in to fend off recession in the United States, while commodity and energy exporters prospered from booming demand from China.

Now, Chinese economic growth is weakening and oil prices are falling, whereas the dollar is riding high on expectations that the US Federal Reserve will raise interest rates from next year. The euro zone economy, meanwhile, is flirting with recession for the third time in recent years.

That leaves the United States as the only buoyant major market for emerging market export economies, especially those based on manufacturing and services.

"Simply increasing broad exposure to emerging markets is no longer enough and it is necessary to discriminate between countries and regions," Richard Titherington, head of emerging market equities, at JP Morgan Asset Management, told a briefing last week.

JP Morgan Asset Management tips Singapore, Taiwan and Thailand as examples of manufacturing nations likely to benefit from a growing US economy.

Commodity exporters such as Russia, Chile, South Africa and Brazil are likely to fare less well because their growth of recent years was driven largely by demand from China, Titherington said.

"Manufacturers have historically benefited from developed market demand faster than commodity exporters," he added.


Those emerging markets that have had to compete with China in importing commodities should benefit from the falling cost of oil. That should help to improve their balance sheets and drive down the cost of production for manufacturing industries.

In India for instance, the cost of importing oil has dropped 12.6 per cent in local currency terms since Brent crude hit a US$147 (S$183.80) per barrel peak in July 2008, the following graphic, based on Thomson Reuters data shows.

Similarly, for Indonesia, the cost of buying oil is down 18 per cent and for South Korea, crude is 37 per cent cheaper.

Avinash Vazirani, a fund manager at Jupiter Asset Management, said India will benefit particularly as it subsidises energy prices on the domestic market. High global oil prices strain the public budget, but these pressures ease as the cost of imports falls.

It is no wonder then that India-focused equity funds have enjoyed the best returns in emerging markets so far in 2014 while commodity exporting Russia brings up the rear.

State revenues in oil-based economies such as Russia are dwindling, leading to wider budget deficits that put pressure on their currencies as well as depressing economic growth.

With Brent crude now at around us$89 per barrel, it is below the US$92 level Saudi Arabia needs to fund its budget. Other oil exporters such as Algeria, Ecuador and Nigeria all need a price well over US$100 per barrel for their budgets, the following graphic shows: http://link.reuters.com/jep82w

"You do have to take oil into account (while allocating). The oil price fall is a relatively positive development for countries such as India, or Turkey which are importers while others such as Brazil and Russia will be penalised," said Jeremy Lawson, chief economist at Standard Life Investments.

However, Lawson and others cautioned that the United States, which is projected to post robust growth by the International Monetary Fund, is a weak engine for global growth on its own.

"There has been a tendency to overstate the strength of the global economic recovery ... There has been too much faith in the ability of US growth to lift all boats," Lawson said.

Simply focusing on manufacturers rather than commodity exporters may not be enough to weather more volatile global markets, however. Investors may need to discriminate further still, to filter out emerging markets that depend on exporting to weaker developed markets in Europe or Japan.

"From a trade perspective, a stronger US should benefit manufacturers, but more Mexico and Asia than emerging Europe, for whom the primary driver is Germany and the European Union," said Craig Botham, an emerging markets economist at UK fund manager Schroders.

Also, as investors have piled into east Asian markets that rely on manufacturing, many such as Thailand are also looking expensive, with stock markets trading well above the emerging markets average on a price-forward earnings basis.

"It's difficult to see how expensive markets that are probably seeing the tail end of an earnings upgrade cycle are going to remain as expensive," said Sam Vecht, an emerging markets fund manager at BlackRock.

Saker Nusseibeh, London-based Chief Executive of Hermes Fund Managers, believes the scenario projected by the IMF of a strong United States contrasting to sluggish Germany and Japan marks a significant shift.

"We used to talk about the global economic cycle. It looks like we have gone back to regional economic cycles," he said.