Emerging Markets: Improved Cyclical Trends After a Long Dry Spell

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1 leadership series september 2016 business cycle update Emerging Markets: Improved Cyclical Trends After a Long Dry Spell Better economic conditions offer a more favorable near-term outlook for growth and equities after cyclical downturn Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research Lisa Emsbo-Mattingly l Director of Asset Allocation Research Cait Dourney l Analyst, Asset Allocation Research Joshua Lund-Wilde, CFA l Research Analyst, Asset Allocation Research KEY TAKEAWAYS Global economic stabilization, including a steadier China, has caused some cyclical headwinds to recede and improved the nearterm prospects for many emerging-market (EM) countries. With the recession ending in global trade, manufacturing activity, and commodity prices, the EM business cycle and corporate earnings outlooks have become more favorable. The recent fundamental improvements in EMs especially relative to low market expectations support our more positive view on EM equities. The U.S. economy continues to experience a mix of mid- and late-cycle dynamics with low odds of recession. We continue to favor global equities and inflation-resistant assets, though smaller asset allocation tilts may be warranted. Manufacturing activity and raw industrial prices have rebounded page #2 China s fiscal stimulus key to EM outlook page #3 EM corporate earnings appear to have bottomed page #4 Despite Brexit, Euro Area economy remains in mid-cycle expansion page #5 Brazil enters early-cycle recovery page #6 Asset allocation implications page #6 Business Cycle Framework page #7 MORE IN THIS ISSUE Fidelity s Asset Allocation Research Team employs a multi time-horizon asset allocation approach that analyzes trends among three temporal segments: tactical (short term), business cycle (medium term), and secular (long term). This monthly report focuses primarily on the intermediate-term fluctuations in the business cycle, and the influence those changes could have on the outlook for various asset classes.

2 leadership series september 2016 For the better part of the past five years, we have highlighted the cyclical challenges facing emerging market (EM) economies as a group. As expected, emerging-market equities lagged those of the U.S. and other developed markets during this period. However, recent improvements in the global economy and EM business cycle trajectories have caused some cyclical headwinds to recede and the near-term prospects for many of these countries to improve. Lingering challenges after a cyclical boom The big story in EMs during the past few years has been the downshifting from rapid growth to a more moderate pace. While the emerging-market category contains a wide variety of countries, there are a handful of common challenges that have defined this period and came to a head during 2015: The end of China s boom China is not only the largest emerging market but also the biggest external influence on the economic performance of many other EMs. In recent years, China s thriving economic growth gave way to a credit-fueled investment boom that left it burdened with massive private leverage, severe imbalances, and overcapacity in the industrial and property sectors. Global trade and industrial recession The ripple effects of China s slowdown both the excess capacity in its industrial sector as well as the drop in import demand were the biggest contributors to the global trade recession in This downturn was defined by weak manufacturing and plummeting commodity prices (see Exhibit 1). The effects have been felt most acutely in emerging-market countries, many of which are commodity producers or have close trade linkages with China. Financial pressures As a result of these and other economic challenges, many EMs faced tighter credit and monetary conditions. Countries such as Russia and Brazil experienced steep declines in the values of their currencies and were forced to hike interest rates to arrest the rise in inflation. The Fed s move to a rate-tightening cycle put additional pressure on global liquidity. Exhibit 1 Commodity Prices vs. Manufacturing Activity After bottoming in late 2015, manufacturing activity and commodity prices have rebounded 12-Month Change Share of PMIs > 50 (3M Avg) 40% 90% EM manufacturing diffusion index 30% 80% Exhibit 2 China Fixed Asset Investment Public spending on fixed assets has risen in China during 2016, while private investment has stalled Change (Year-Over-Year) 45% 40% Private 35% 20% 70% 30% 10% 0% 60% 50% 25% 20% 15% Public 10% Raw industrials prices 40% 10% 5% 20% Jul-2012 Sep-2012 Nov-2012 Jan-2013 Mar-2013 May-2013 Jul-2013 Sep-2013 Nov-2013 Jan-2014 Mar-2014 May-2014 Jul-2014 Sep-2014 Nov-2014 Jan-2015 Mar-2015 May-2015 Jul-2015 Sep-2015 Nov-2015 Jan-2016 Mar-2016 May-2016 Jul % 0% Jan-2011 Apr-2011 Jul-2011 Oct-2011 Jan-2012 Apr-2012 Jul-2012 Oct-2012 Jan-2013 Apr-2013 Jul-2013 Oct-2013 Jan-2014 Apr-2014 Jul-2014 Oct-2014 Jan-2015 Apr-2015 Jul-2015 Oct-2015 Jan-2016 Apr-2016 Jul-2016 Source: Commodity Research Bureau, Markit, Haver Analytics, Fidelity Investments (AART), as of Jul. 31, Source: NBS, Haver, Fidelity Investments (AART), as of Jul. 31,

3 business cycle update: Emerging Markets: Outlook Improves FOR ECONOMY AND STOCKS Global stabilization, base effect support EMs in near-term While some of these challenges have by no means disappeared, the near-term cyclical outlook has improved materially for EMs as a group. As we highlighted nine months ago in our 2016 outlook (see Leadership series article Global Environment Poised to Stabilize as 2016 Progresses ), global stabilization in 2016 would provide the backdrop to end the sharp declines in emerging-market economies, commodity prices, and EM currencies. We believe the following cyclical changes are beginning to take shape as we projected: China s stabilization After a volatile 2015, policymakers in China have demonstrated a commitment to near-term stability, and have implemented substantial fiscal stimulus measures in order to support real activity (see Macro Update: China). Positive base effect of global stabilization Steadiness in China has contributed to a reacceleration in global manufacturing activity, a firming in global trade activity, and a rebound in commodity prices (Exhibit 1). While these trends do not imply a rapid reacceleration Exhibit 3 Real GDP Growth Forecasts, EM countries are likely to grow faster than developed markets over the next 20 years Annualized Rate (%) Developed Markets Emerging Markets Italy Japan Spain Netherlands Germany France Canada Australia Sweden U.K.* U.S. South Korea Russia Thailand Turkey Brazil Mexico South Africa Colombia Peru Malaysia China Indonesia Philippines India * U.K. growth estimate may vary based on Brexit implications. Average forecasts are GDP weighted. GDP: gross domestic product. Source: Fidelity Investments (AART), as of Dec. 31, back to boom times, they benefit from the ability to grow off a very low base. Improved cyclical outlooks in many EMs Many EMs are now receiving support from a similar base effect. After settling at a lower level, there now exists an opportunity for an upside surprise for some countries in economic activity and corporate earnings growth. For example, after falling to a multi-year low in late 2015, our diffusion index of EM manufacturing activity has rebounded significantly over the past 10 months (Exhibit 1). Raw industrial prices have risen into positive territory on a year-over-year basis for the first time in more than two years. After corporate earnings declines of nearly 20% in 2015, growth is no longer deteriorating and expectations appear to have inflected positively. Easier financial conditions The more-gradual-than-expected pace of Fed tightening in 2016, as well as additional global easing after June s Brexit referendum, has allowed EMs to enjoy more favorable liquidity conditions. The recent rally in EM debt instruments has pushed yields down close to historically low levels, lowering the borrowing cost for EM sovereigns and many corporates. Cyclical risks While financial market turbulence can always rear its head, the principal risk to our positive near-term outlook for EMs is China. China s stabilization has been heavily dependent on policy action, as demonstrated by the rise in government spending on fixed asset investment (FAI) alongside the decline in private-sector FAI (see Exhibit 2). Ultimately, China will need to enact structural reforms to clear out the excessive credit and industrial capacity, which will likely entail higher economic and financial risks. Similarly, we do not expect emerging markets as a group to experience a robust, early-cycle type reacceleration anytime soon. Many EMs share cyclical and structural challenges such as a credit overhang and overcapacity, and still face a long-term adjustment to a slower growing global economy. Strong secular prospects for emerging markets Beyond the cyclical outlook, we believe EMs have relatively positive secular growth prospects (see Leadership Series article Secular Outlook for Global Growth: ). We 3

4 leadership series september 2016 expect that over the next 20 years, emerging-market countries will grow faster than developed markets (see Exhibit 3), in large part due to faster labor force growth. In addition, several EMs with youthful demographics such as the Philippines, India, and Indonesia also have the benefit of considerable catch-up potential to grow productivity rates off a relatively low base. The largest risk to this relatively rosy secular outlook is the potential for financial instability, particularly in China. Historically, growth-destroying financial crises most often occur after a large build-up of imbalances, and financial fragility is most pronounced in China and in EM Asia. Asset allocation implication: Positive cyclical outlook for EM equities Our business cycle framework is founded on the principle that in the near and intermediate term, asset prices are influenced more by the change in the rate of growth rather than the level of growth itself. In other words, over the next 12 months any improvement in cyclical trends in EMs is likely to outweigh investor concerns about the diminished pace of Exhibit 4 Emerging Market Earnings Growth The profit outlook has improved for EMs, with earnings growth turning positive in some countries Growth (12-Month Trailing) 60% Emerging Markets Brazil India Mexico 40% absolute growth relative to the prior global boom period. As a result, the fundamental improvements we are observing especially relative to low market expectations have made us more positive on EM equities during the course of 2016 than at any point during the past few years. Positive drivers for EM equities include: U.S. business cycle outlook: Historically, EM equities perform well on a relative basis during the U.S. late cycle, partially due to commodity-exporters benefiting from a pickup in inflation and rising commodity prices (see Macro Update: U.S.). EM business cycle fundamentals: The corporate earnings outlook has improved, with profit growth trends improving and turning positive in countries such as Brazil, India, and Mexico (see Exhibit 4). According to our business cycle models, China has stabilized, Brazil has entered early cycle, and India s mid-cycle expansion continues (see Macro Update: Global). Foreign Exchange (FX): Our analysis indicates that many EM currencies are either at fair value or undervalued relative to the dollar, and we anticipate that FX will no longer be a headwind for USD-based investors in the near term. Secular drivers: Over the long term, strong growth prospects and more attractive valuations relative to developed markets make EM equities a key component of a global equity portfolio. 20% 0% 20% 40% 60% Jun-2011 Sep-2011 Dec-2011 Mar-2012 Jun-2012 Sep-2012 Dec-2012 Mar-2013 Jun-2013 Sep-2013 Dec-2013 Mar-2014 Jun-2014 Sep-2014 Dec-2014 Mar-2015 Jun-2015 Sep-2015 Dec-2015 Mar-2016 Jun-2016 Source: MSCI, FactSet, Fidelity Investments (AART), as of Jul. 31,

5 business cycle update: Emerging Markets: Outlook Improves FOR ECONOMY AND STOCKS Business Cycle: Macro Update The U.S. and global economies have continued to gain momentum despite post-brexit headwinds. The U.S. continues to experience a mix of mid- and late-cycle dynamics with low odds of recession, while the global economic expansion continues at a slow but steady pace. United States: Late-cycle indicators elevated, recession odds remain low Consumer supports continued expansion Favorable employment conditions have helped soak up a significant amount of excess slack in the labor markets. Hiring remained solid in July, although the pace of gains has decelerated as is consistent with historical late-cycle dynamics. Wage pressures remain in an uptrend and continue to support consumer spending, particularly for housing. 1 Both core and headline inflation measures are poised to end 2016 above 2%, as the uptrend in wages is keeping core inflation measures firm while oil prices will soon begin to lap late 2015 s subdued levels. Tight labor markets and rising income suggest that the U.S. consumer is providing a solid foundation for continued U.S. expansion. Mixed outlook for business sector Stabilizing external conditions have helped the U.S. business sector regain footing from the recent slowdown. The reacceleration in industrial activity, as well as fewer headwinds from oil prices and the dollar, suggests an opportunity for earnings to surprise to the upside in the near term. In fact, second quarter S&P 500 earnings appear to have risen for a second consecutive quarter in Q2 the first time since mid Late-cycle trends continue to build, however, with banks further tightening lending standards for businesses. 3 Moreover, rising wage pressures are likely to begin weighing more heavily on corporate profit margins. The corporate sector is experiencing a modest upswing, but late-cycle trends are likely to cap the upside. Global: Stabilization continues despite Brexit risk U.K. recession risk elevated post-brexit Brexit increased the risk of recession in the U.K, although so far the impact on real economic activity has appeared limited. Business investment expectations and consumer confidence 1 Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments (AART), as of Jun. 30, Source: Standard & Poor s, Fidelity Investments (AART), as of Aug. 11, Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of Aug. 1, turned sharply lower in the weeks after the referendum, but consumers remain resilient amid a healthy jobs market, and the policy response from the Bank of England could hold off a sharp contraction. Political uncertainty from the Brexit aftermath remains a headwind for business investment, but the household sector is underpinning the UK s late-cycle expansion. Europe: Expansion on track despite Brexit headwinds The Euro Area remains in a mid-cycle expansion phase, benefiting from a stronger manufacturing sector and improving credit conditions. The French consumer sector appears buoyant; easing German mortgage conditions signal a potential reacceleration in construction; and the probability of recession in Italy has declined alongside concerns about its undercapitalized banking system. European economic sentiment indicators have, so far, been little changed following the Brexit vote (see Exhibit A). Europe s domestic economy appears strong enough to continue its tepid cyclical expansion despite rising political uncertainty. China stabilizing amid fiscal response A downshift in growth at the end of an overextended credit boom has caused China to remain in a growth recession for the past Exhibit A Euro Area Economic Sentiment Economic sentiment in the Euro Area remains steady post Brexit Long-term Average = Source: European Commission, Haver Analytics, Fidelity Investments (AART), as of Jul. 31,

6 leadership series september 2016 year, but the economy has steadied during the past several months. Recent economic stabilization can largely be attributed to a strong fiscal policy response that has supported the industrial and property sectors. After declining for the past four years, producer prices have started to flatten, signaling the worst of the deflationary phase could be passing. China appears to be nearing the end of a growth recession, but greater structural reforms will likely be needed for a sustainable reacceleration. Brazil entering an early-cycle recovery Brazil is showing signs of exiting one of the most painful recessions in its history. While sentiment indicators remain at relatively low levels, their sharp improvement in recent months is a classic sign of an early-cycle recovery. Inflationary pressures have recently decelerated, although year-over-year price growth of 9% is keeping the central bank from cutting rates from a stillrestrictive level of 14.25%. Recession probability indicators have declined sharply, but lower inflation and a shift toward monetary easing are likely needed to generate a sharp acceleration in growth. India: High relative growth with improvements on the margin With limited exposure to Chinese trade demand and as a net beneficiary of lower commodity prices, India s economy was able to weather the global slowdown of 2015 better than many emerging-market economies. India is in a modest mid-cycle expansion, helped by steady improvement in its industrial and consumer sectors. Monetary easing from 2015 is beginning to have a positive lagged impact on credit conditions. Economic growth remains relatively high and stable, but does not appear to be in a position to accelerate meaningfully. Global summary: Stabilization continues Most post-brexit data show the global economy continues to modestly reaccelerate across a variety of metrics. Roughly 70% of countries manufacturing bullwhips leading indicators for manufacturing activity were in expansionary territory in July. Japan has begun to recover from a mild recession, underpinned by improvements in the consumer sector. Policymakers announced a large stimulus package in July, but the size of the impact remains to be seen. Commodity-exporting countries such as Canada and Australia as well as major China trading partner South Korea remain in late-cycle expansions and continue to improve incrementally alongside China s stability. The tepid global economy continues to gain cyclical traction. Outlook/asset allocation implications The post-brexit spike in market volatility has been followed by several weeks of summer calm. The shift to a more accommodative monetary stance by major central banks likely played a large role in this turnaround. However, the resilience of the global economy in the face of another headwind has probably also been a factor, and incremental signs of global stabilization continue to build. These trends are particularly noticeable among many of the EM economies, even if a return to vibrant growth is likely to remain elusive. Consistent with our business cycle view that asset prices tend to respond to cyclical improvement, we continue to favor global equities. In particular, EM equities still enjoy the benefit of low growth expectations and relatively attractive valuations. The rising probability of a U.S. shift into the late-cycle phase suggests market volatility could return and that smaller cyclical asset allocation tilts may be warranted at this phase of the cycle. A move toward late-cycle dynamics would also tend to favor assets that benefit or are more resistant to inflation, including EM and energy-sector equities, TIPS, and shorter-duration bonds. 6

7 business cycle update: Emerging Markets: OUTLOOK IMPROVES FOR ECONOMY AND STOCKS Business Cycle Framework The world s largest economies are in various phases of the business cycle. Cycle Phases Inflationary Pressures Red = High EARLY Activity rebounds (GDP, IP, employment, incomes) Credit begins to grow Profits grow rapidly Policy still stimulative Inventories low; sales improve MID Growth peaking Credit growth strong Profit growth peaks Policy neutral Inventories, sales grow; equilibrium reached Germany India LATE Growth moderating Credit tightens Earnings under pressure Policy contractionary Inventories grow; sales growth falls RECESSION Falling activity Credit dries up Profits decline Policy eases Inventories, sales fall + Economic Growth Brazil* RECOVERY Italy and France U.S. South Korea EXPANSION Australia Canada U.K. CONTRACTION China* and Japan Relative Performance of Economically Sensitive Assets Green = Strong Note: The diagram above is a hypothetical illustration of the business cycle. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. * A growth recession is a significant decline in activity relative to a country s long-term economic potential. We have adopted the growth cycle definition for most developing economies, such as China, because they tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend tends to matter the most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed economies. Please see endnotes for a complete discussion. Source: Fidelity Investments (AART). Authors Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research Cait Dourney l Analyst, Asset Allocation Research Lisa Emsbo-Mattingly l Director of Asset Allocation Research Joshua Lund-Wilde, CFA l Research Analyst, Asset Allocation Research The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity s asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation. Asset Allocation Research Team (AART) Senior Analysts Austin Litvak and Jacob Weinstein, CFA, and Research Analyst Jordan Alexiev also contributed to this article. Fidelity Thought Leadership Vice President Kevin Lavelle provided editorial direction. 7

8 leadership series september FMR LLC. All rights reserved Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the informa tion available at that time, and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice, and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. Fixed-income securities carry inflation, credit, and default risks for both issuers and counterparties. Although bonds generally present less short-term risk and volatility than stocks, bonds do contain interest rate risk (as interest rates rise, bond prices usually fall, and vice versa) and the risk of default, or the risk that an issuer will be unable to make income or principal payments. Additionally, bonds and short-term investments entail greater inflation risk or the risk that the return of an investment will not keep up with increases in the prices of goods and services than stocks. Increases in real interest rates can cause the price of inflation-protected debt securities to decrease. Stock markets, especially non-u.s. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Investing involves risk, including risk of loss. 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Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep. Economically sensitive asset classes such as stocks tend to experience their best performance of the cycle. During the typical mid-cycle phase, the economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening. Economically sensitive asset classes tend to continue benefiting from a growing economy, but their relative advantage narrows. During the typical late-cycle phase, the economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing. 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