There’s life left in the rally

The outlook across emerging markets remains mostly bright, though we do see diverging outlooks as financial conditions likely tighten in 2018 due to stimulus withdrawal by developed markets.

Some are sceptical of the sustainability of the current emerging market rally given its credit-driven origins, once again being sourced from China. However, a mix of a deep economic adjustment, ongoing reforms and spreading growth that now includes broad emerging markets as well as Europe suggests a more durable outlook despite some stimulus withdrawal.

While China’s debt levels are uncomfortably high, the credit cycle has lasted longer than most had thought possible due largely to the high savings rate. While credit growth cannot sustain at the current pace indefinitely, it can maintain these levels for a while as reforms gradually push the economy into a self-sustaining balance.

China has in effect replaced the US as the primary source of demand growth, not just for investment but increasingly for consumption. In a paper published by the Brookings Institution in February 2017, of the more than 700 million people expected to enter the middle class over the next five years, 90% will live in Asia.

So far US tightening has done little to slow emerging market growth, mainly because yields have failed to meaningfully lift while the dollar remains relatively weak.

A chief concern is the tightening of financial conditions, which is likely to gather pace in 2018 following the increasing wind-down of developed market quantitative easing. In our view, such tightening would have an unequal impact across emerging markets. Those most dependent on easy liquidity to finance external imbalances, such as Turkey and South Africa, will likely feel the pain compared with more balanced peers positioned to survive tighter conditions.

Most emerging markets are also well positioned to survive weaker demand for exports, though slowing demand seems unlikely anyway given that Europe is still early in its recovery. The sector is much more durable than it was 10 years ago, leaving it less vulnerable to tighter conditions emanating from developed markets.