Reasons to be gloomy about emerging market prospects

It is hardly surprising that global growth scares would hit emerging markets more powerfully than developed markets. By the end of last week, share prices in developed markets had recovered most of their losses, while global emerging market equities were down 1.7 per cent and Asian markets, usually the most resilient, had dropped 0.9 per cent. If earlier in the week emerging market assets reacted in a more contained way, that "reflected the fact that they had already weakened meaningfully, so positioning was arguably lighter", wrote analysts at Goldman Sachs.

Emerging market currencies have been ailing for a while and are down more than 5 per cent for the year. While emerging market investment grade debt has held up better, it has done so precisely because of slowing growth and more disinflationary and deflationary pressures.

There are structural as well as cyclical reasons to continue to be gloomy about emerging market prospects - particularly in Asia. At the same time though, investors should adopt a more nuanced view. While emerging markets are not about to decouple from the rest of the world, the divergence in performance within that overly broad category may become more dramatic in future.

Asia in particular has to reinvent itself. Its export-led growth model is unlikely to work as well in future as it has for the past decade. Asian exports peaked in 2011 and since then manufacturers' pricing power has only grown weaker. Most importantly, China is shifting to a more domestic demand-led model. In recent years, Chinese exports had major spillover effects for the rest of the region via supply chain linkages, but those are now beginning to dwindle, according to Andrew Tilton of Goldman Sachs in Hong Kong. Moreover, China's market share has stabilised, suggesting trade gains will be more and more a zero-sum game.

At the same time, developed markets are growing more slowly. Worryingly, the US "will no longer be the consumer of first resort for emerging markets, given its improved competitiveness and reduced energy dependence", notes Shweta Singh, a senior economist at Lombard Street Research in London.

Moreover, the cost of credit in the world is increasing, making Asian-style debt-fuelled growth more expensive. Financial conditions generally are tightening for emerging market companies as spreads widen and local currencies continue to drop.

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The Morgan Stanley trade partly reflects the beneficial effect that falling oil prices have on India's current account and inflation, as well as the two countries' differing dependence on US dollar funding. But more profoundly, the trade reflects a general reversal in the relative fortunes of commodity importers and exporters. That reversal is taking place against a backdrop of a slowing China, which in turn is leading to lower demand for coal, iron, and oil.

In large part thanks to lower oil prices, India's current account deficit is at its lowest level in six years. By contrast, Indonesia's deficit more than doubled to 4.3 per cent of GDP in the second quarter. A more benign environment could lead to a sustained virtuous circle in India, in which lower inflation helps promote a stable currency and makes it possible in turn for the central bank to cut interest rates.

India has already accumulated a sizeable war chest of about $315bn in reserves, compared with about $110bn for resource-rich Indonesia. Moreover, India is far less reliant on US dollar funding. Indonesia depends on foreigners to take 37 per cent of the debt issued in its local debt market. "Soft commodity prices, an uncomfortable current account deficit and rising real interest rates have conspired to drive Indonesia's GDP growth down from a peak of 6.5 per cent to a lower growth channel of 5.0-5.5 per cent for 2014-2016," Morgan Stanley says.

Divergence and relative shifts in fortunes are also likely in Latin America. Mexico appears to have stronger short term prospects than Brazil or Chile, since 80 per cent of its exports go to the US, Ms Singh adds. A strong US dollar also helps Mexico.

But a benign world where virtually all emerging markets are battened on demand from their richer neighbours is unlikely to return any time soon.

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