First half surprises
12 June 2018
2018 has already seen its fair share of surprises. Nearly at the mid-point, we’ve seen a shift (even if temporarily) in US-North Korea relations that was deemed unbelievable just six months ago; the consensus around synchronised global growth has weakened; the US is moving towards protectionism; and the ZTE debacle crushed the myth of world-beating Chinese innovation. In emerging markets (EM), the optimism that started the year has largely faded in the face of rising rates, a stronger dollar, and higher oil prices leading to more volatility and less risk appetite. What is perhaps most surprising (though certainly receiving less attention) is the fact that the market stress and negative growth shocks in EM has occurred amid unexpected strength in China’s economy. This highlights two uncomfortable truths about EM: first, though intra-EM trade has grown and China’s economy exhibits a far larger influence over the EM cycle than it did ten years ago, EM has yet to ‘decouple’ from the developed market and dollar cycle; second; it is highly unlikely China can maintain current levels of activity, and will slow in the second half. Given that we have already seen negative growth surprises in Brazil, Russia, Indonesia, and South Africa, among others, alongside strong Chinese growth, the environment could get more difficult if the China factor also turns less supportive.
For most of 2018, China has been able to have its cake and eat it too. The government has emphasised de-risking the financial sector and cleaning up the environment, causing credit growth to slow substantially. Our measure of total credit (including hidden credit not captured in official statistics) slowed to 10.1% year-on-year (y/y) from a peak of 21.9% y/y in March 2016 (see Chart 10). But the government has not had to pay any price for these efforts as the economy has barely slowed: PMIs have held steady at five-year highs, manufacturing industrial production (according to official data) has held steady, and property sales have hovered near all-time highs (see Chart 11). Although pessimists have been proven wrong over their China forecasts this year, most factors are still pointing to slowing growth – borrowing costs are higher; trade tensions look to sap sentiment even in the event they are smoothly resolved (which we doubt); and industrial production volumes (our own measures that looks to more accurately measure production activity) slowed over the first quarter.
So what should investors look for as we moved into the second half of the year? The first would be production volumes, which tend to reflect two themes – trade tensions and environmental shutdowns. Production slowed sharply over 4Q17 and 1Q18 as environmental policies forced shutdowns and looming trade threats pushed businesses to run down inventories and slow current production. However, this figure bounced back in April to 6.6% y/y from 1.4%, reflecting an easing of environmental policies. The impact of on-again-off-again trade tensions with the US are as yet unclear and the negative sentiment impact could yet slow production. The housing market is the other key factor. Following an unexpected bounce in Q1, it’s unclear where we are in the current cycle. On the one hand the current edition is among the longest since housing has been deregulated, but on the other hand inventories are at multi-year lows. On balance, we expect a slowdown, which further dampens the outlook for broader EM.