The Envestnet Edge, September 2015
China, Commodities, and Crisis: What's Next for Emerging Markets?
China’s growth story fueled global markets for years, and the recent market rout raises concerns that the spigot may be tapping out. But is it really? Emerging markets, currently out of favor with investors, are showing signs of domestic economic growth driven by an expanding middle class. Could these economies, along with China, re-emerge as bright spots in the global markets?
In August, equity markets finally displayed the volatility that many had been anticipating. Other asset classes, including currencies, high-yield and emerging market bonds, and, of course, energy and commodities, had roiled throughout the year. But equities had been largely immune—until now.
The sell-off was attributed widely to accelerating worries about the tenability of China’s economic growth, and how its sharp deceleration would negatively affect global economies. For more than a decade, skeptics warned that China’s economic model, dependent on exports and state spending on infrastructure, was on the verge of a hard landing. But over the summer, those concerns began to emanate from China itself, and its domestic equity markets began to crash. Although those markets are largely unconnected to global markets, global equities began to sell off hard, as investors worldwide began to question whether China’s day of reckoning had arrived.
Other factors played a part for sure: low volumes in the normally slow summer month of August; a high level of algorithmic and program trading; the ongoing question about when the Fed will begin to raise short-term rates. But the China question looms largest, especially because as China goes, so goes global growth.
So, will China slow so much that global growth is imperiled? If the answer is ‘yes’, then, indeed, we should be very concerned about the stability of emerging markets, and the viability of international bonds and financial assets that are exposed to those trends (which is most of them). But there are strong reasons why the answer could be ‘no’.
2 billion and counting
When our children and grandchildren look back at the first 15 years of the 21st century, it is likely that the addition of billions of people to the global middle class will be a dominant theme. And that China—and its string of double—digit growth years—was the anchor. As hundreds of millions of Chinese moved from the countryside to newly constructed cities, China’s appetite for raw materials fueled a global economic boom. From Chile to Brazil to swaths of sub-Saharan Africa to Indonesia and Southeast Asia, more than a billion people in turn benefitted from China’s growth.
China also became a market for high-end finished goods: turbines, semi-conductor equipment, locomotives, airplanes, and tempered steel. China’s trading partners prospered, from Germany to Japan to South Korea to the United States. In fact, the only large country that grew almost entirely on its own internal steam was India, which, lagging China’s impressive trajectory, was powered by its domestic market.
China also reaped benefits from the globalization of supply chains, becoming the low-cost global producer for Europe and the United States. At the same time, it became a highly desirable market for U.S. and multinational companies looking to tap China’s burgeoning middle class consumers. Businesses such as Apple, Kentucky Fried Chicken, Federal Express, and Walmart all gained from China’s growth.
China’s growth resulted not only in the creation of a new Chinese middle class several hundred million strong, but also a global middle class several billion strong. That is why the prospect of a severe China slowdown is of such concern to so many.
Because so much of the world has changed so dramatically and so quickly is the very reason why this train of global growth will be so difficult to derail. It may face challenges in the year ahead, but the momentum is powerful.
Think about it. The last time there was global concern about the viability of emerging market economies was the Asian currency crisis and the meltdown of the Russian ruble in the late 1990s. Many countries, ranging from Latin America to Asia, had autocratic, inept governments with high levels of foreign debt and few reserves.
Today, much of the world has democratically elected governments that are accountable for economic growth and prosperity. Brazil, for instance, may be facing recession and scandal, but its democratically elected government knows that if it cannot enact meaningful reforms to enlarge the middle class, it will lose its mandate to govern. In addition, over the past decade, many of the countries that have advanced from China’s rise have not squandered their profits.
Instead, they have bolstered their reserves and invested in infrastructure and education—perhaps not as much as they could or should have, but incomparably more than twenty years ago. They have strengthened their foreign reserves, and many have favorable current account balances, all of which better positions them to weather storms and downturns than was the case in the late 1990s when their high debt made them vulnerable to the ebbs and flows of international credit and finance.
Today, many countries are overly reliant still on the export of raw materials and oil. That is a real weakness in light of China’s diminished appetite and the efficiency evolution sweeping the planet that translates into less demand.
But that reliance is offset by the surge in consumer demand within those countries. In fact, the growth of domestic consumer economies is perhaps the strongest reason to suspect that even a significant China slowdown does not portend a general financial and economic crisis. India is the most compelling example of a vast non-Western economy that is surging because of its own internal middle class market, rather than reliance on exports or commodities. It is not alone: countries such as Nigeria and the Philippines, and to a large extent Indonesia, which have a combined population approaching half a billion people, are exhibiting similar dynamics (despite Nigeria’s former dependence on oil exports and Indonesia’s extensive commodity boom and bust).
Although the commodity bust and China’s shifting economic mix have been and will continue to be unsettling, and at times painful, these are positive adjustments for the world. They move the next stage of global evolution away from selling stuff and digging stuff and towards billions of people using stuff. They move the world away from selling to the highest bidder or to the one with the largest appetite for metals and oil and towards a world ever-more grounded on billions of people striving to create a better life for themselves and their families.
To believe that we are on the brink of a significant global crisis, therefore, is to believe that several billion people in the world formerly known as ‘developing’ cannot make the transition that a billion people in the developed world already have. It is to believe that they are both incapable of good governance, and unable to craft a formula for their own wellbeing. That may, of course, be true, but if it is, our worries will be more substantial than what asset classes to invest in and how much.
In recent history, industrialization and globalization spawned a Chinese middle class of millions that in turn created a global middle class more than a billion strong. With democratically governed countries having bolstered their reserves and invested in infrastructure and education to enlarge their middle class, they are well positioned to withstand the challenges they could face from China’s shifting economic mix. The next phase of global evolution will be towards consumption, as several billion people strive to create a better life for themselves and their families. All of this should have positive ramifications for financial markets.
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