Why top-down currently trumps bottom-up in emerging markets

Emerging markets are currently facing two fairly striking opposing forces, in particular, favourable top-down macro forces or factors, set against fairly weak/mixed bottom-up country stories.

At present, top-down forces are dominant but we believe this is unlikely to last. We are of the view that country specific stories will come to the fore with credit differentiation (alpha) rather than beta plays being the order of the day. Here we look at how some of the global macro forces and bottom-up country specific stories are playing out.

Goldilocks global growth

Global growth data is still telling a story of a synchronised global reflation/recovery. Led by Chinese reflation from mid-2015, but coming in parallel with a sustained US recovery as balance sheet healing appears near complete. This is now being joined by new found confidence in Europe, helped by recent political wins for more mainstream forces, not least that of Emmanuel Macron in France.

Central banks still providing liquid refreshment

Despite the nascent and now seemingly well entrenched recovery, developed market central banks seem loathed to tighten aggressively. The Federal Reserve is tightening but at a pace which seems manageable – and less pressure therein now as the ‘Trump bump’ seems to be fading. On the latter, there are concerns that the chaos and political flux around the Trump presidency could act to break the US recovery, as ‘soft’ data converges with hard data.

Chinese authorities are beginning to tighten but are content that the economy is growing at a robust pace to ensure no big negative surprises this side of the leadership change.

In Europe, we think the European Central Bank (ECB) still has its eye on domestic politics and the threat from populists after the shock of Brexit and the Trump victory. In our opinion, the ECB needs to ensure robust growth and job creation to help mainstream politicians counter the risk from the far-right, far-left and the anti-immigrant rant. We think the ECB will only begin to take its foot off the monetary gas when the German elections are done in September. Interestingly, we are yet to see much evidence of a splurge in developed market (DM) investment/mergers & acquisitions, as DM companies still seem cautious as to the durability of the recovery. This is leaving excess liquidity pumping around global markets and finding its way into risk assets, including emerging markets (EM).

Trump’s protectionist desires seem to have been caged and geopolitical risks have been contained – so far

While we started the year concerned around the protectionist impulses of President Trump, in reality his ambitions have been contained by hard economic reality (for example efforts to reform The North American Free Trade Agreement (NAFTA) have come up against the realisation that this will hurt US businesses and consumers through higher inflation) and by geopolitical needs (the need to cooperate with China to mitigate the threat from North Korea).

Fears that Trump would translate domestic policy failure into foreign military adventures have so far failed to come to fruition. In many respects foreign policy under Trump has gone back to default GOP settings, with a return to more traditional bilateral allegiances with Saudi Arabia, Egypt, Turkey (perhaps) and Israel.. Trump could so easily still move back outside the box, but early policy mishaps over Russia, the One-China policy and Israel-Palestinian relations have seen Trump look to minimise risks on the foreign policy front. Encouragingly, the US seems to be working and engaging with China over North Korea.

Bottom-up

Mexico

Has perhaps managed to fend off the worst protectionist impulses around a border adjusted tax (BAT) from the US, but the outcome might well be ‘contagion’ from the Trump effect into its own political scene, with a more populist agenda in the run up to its own elections.

South Africa

Internal battles over the succession to President Zuma are keeping political risks elevated, weighing down on growth and investment and keeping many investors on the side-lines. Well known structural vulnerabilities are not being addressed, while the country still remains vulnerable to deteriorating public finances and ratings downgrades.

Russia

Russia’s balance sheet is strong, but the economy fails to produce meaningful growth, and stagnation remains the dominant theme. This likely reflects deep structural weaknesses which the Putin regime continuously fails to address – these relate to the weak business environment (corruption, bureaucracy, red tape, rule of law and protection of property rights). Meanwhile, Putin’s continued geopolitical battle with the West we think just continues to deter foreign and domestic investment.

China

Probably fits into both the top-down and bottom-up view. The top-down story is that the fiscal/monetary stimulus from mid-2015 onwards seems to be keeping real GDP growth elevated, buying time through the leadership change to year end, and likely enough for the global growth/reflation trade to sustain this year. Beyond that the question marks remain as to whether the Chinese authorities have the means to bring about the rebalancing of the Chinese economy, and deleverage gently. In our opinion, they certainly still have a strong enough balance sheet to cushion the impact, but the problems are just building.

Tim Ash is emerging markets senior sovereign strategist at BlueBay Asset Management