Developed strength and emerging weakness

Since 2009, robust emerging markets have managed to prop up global growth despite developed market recessions and crises. But that dynamic has now changed, argues Ben Bennett, credit strategist at Legal & General Investment Management (LGIM).

Brazil and Russia are currently experiencing economic contractions and Chinese growth is slowing. At the same time, the US has recovered from its traditional slow start to the year and the euro zone is gradually emerging from its drawn out recession. Developed strength, or emerging weakness – what will win out?

Developed markets on the up?
Taking developed markets first, confidence is improving, and both Europe and the US are currently growing above potential with tightening labour markets suggesting the tantalizing prospect of accelerating wages. The hope is that workers use their expanding salaries to consume more, prompting more production with the result that a positive feedback loop takes hold. The counter-argument is that high debt and sluggish growth means companies cannot afford higher wages, and will instead cut workers to try and maintain profitability. The evidence ebbs and flows, but there has been a boost for the optimistic case in recent months, particularly from a robust US housing market, recovering European retail sales and nascent UK wage growth. Indeed, if they were operating in isolation, the US Federal Reserve and even the Bank of England would probably be raising interest rates very soon. But they are not in isolation.

Emerging markets slowdown
Within emerging markets (EM), Brazil and Russia are experiencing deep recessions, and many other commodity exporters are also under severe pressure. The common link of course is China’s economic slowdown. It’s well known that China underwent a massive debt-fuelled investment surge
following the collapse of Lehman Brothers, boosting demand for raw materials across the globe.

But such a rapid burst of activity naturally led to some capital misallocation and declining investment returns. Indeed, overinvestment combined with extraordinary debt growth are often precursors to a recession, particularly if triggered by an asset bubble bursting, as has clearly happened this year in the Chinese stock market. The trouble is that it is very hard to judge Chinese economic activity. Developed market GDP figures are not particularly accurate when first released due to measurement problems, leading to large subsequent revisions. Despite the huge resources at their disposal, China must also suffer from such measurement difficulties, which makes the announcement of 7% for Q2 GDP growth a rough estimate at best. The collapse in commodity
prices and declining world trade highlights the slowdown in Chinese heavy industrial activity, and while the service sector is doing better, it may not be able to fully offset such weakness.

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