March/April 2014 PNC Investment Perspective Decoupling of Developed and Emerging Markets? Jim Dunigan Mr. Dunigan is Executive Vice President and Managing Executive, Investments for PNC Asset Management Group. He has served in a variety of client advisory, investment management and executive roles with PNC since 1987. There is frequent discussion, in this era of globalization and increased sharing and velocity of information, regarding the interdependence of economies. This issue arises particularly in the case of emerging market countries. A question to consider when thinking about emerging markets is whether the developed world can decouple from troubled countries both in economic and financial market terms. IN THIS ISSUE Decoupling of Developed and Emerging Markets? The State of the Union A question often debated is how dependent emerging market economies are on more developed countries for economic strength. Decreased reliance benefits emerging market economies when developed economies experience downturns, although it may work to their detriment when developed economies are strong. Conversely, there are reasons to believe that the developed world can remain decoupled from emerging markets, a benefit for times when emerging markets are experiencing difficulties. Decoupling seemed to be demonstrated in 2001, continued on page 2 This piece is brought to you by our parent company, The PNC Financial Services Group, Inc.
2 PNC Investment Perspective continued from page 1 when the post-tech bubble recession was primarily confined to the U.S., Western Europe and Japan. Decoupling did not hold as true during the global recession of 2008/2009, where aggregate emerging market GDP was negative in the fourth quarter of 2008. Emerging markets did, however, experience a much stronger rebound from the global recession than developed economies. There have been cycles of greater and lesser dependency between developed and developing economies over time. After World War II, the growth of emerging market economies was highly dependent on the economic state of developed economies, and most strongly reliant on the U.S., Western Europe and Japan. Exports of commodities or basic goods to these countries were the main basis of economic growth for developing countries. Therefore, when developed economies were doing well and demand for commodities was high, emerging markets benefited. Similarly, when developed economies were in recession, the negative effects trickled down to developing economies. Total Exports of Emerging Markets vs. Developed Markets Index, 1991=100 1,500 1,300 1,100 900 700 500 300 100 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Decoupling did not hold as true during the global recession of 2008/2009, where aggregate emerging market GDP was negative in the fourth quarter of 2008. In the last few decades, some emerging market countries have progressed and diversified their export goods and services. From raw or basic manufactured goods, they have evolved to produce more complex, higher-level goods. Many of these countries have experienced rapid industrialization and urbanization. This has resulted in a four-fold increase in the dollar value of exports in emerging market economies versus only doubling among developed economies. They have also been able to diversify their trading partners away from purely developed countries to include a significant percentage of trade with other emerging market economies. Demand in those countries for more upscale goods has increased as the population has grown more affluent. Source: PNC Emerging Markets Developed Markets It is important to remember that different emerging market countries vary widely in potential exposure to developed country economies. In fact, most emerging economies are still highly tied to developed economies. Countries that are less exposed to developed markets include China and India, both of which were less impacted than other developing economies during the global recession. Other countries, such as Mexico, which is highly dependent on the U.S., or emerging Eastern European countries, which are tightly tied economically to Western Europe felt the effects much more deeply. It is important to remember that some emerging market economies are still relatively fragile, and lesser dependence is not a guarantee of strength. As we have seen recently, both China and India have experienced economic turbulence in the last year. In addition, developed economies still make up 70% of global production. continued on page 3
3 PNC Investment Perspective continued from page 2 As emerging market countries keep progressing and growing economically, they will probably seek to increasingly diversify the countries to which they export. Developing vs. Developed Country GDP 100 90 80 We believe that decoupling is something that could continue to develop over time. As emerging countries keep progressing and growing economically, they will probably seek to increasingly diversify the countries to which they export. However, we believe there are limits to how far decoupling can go: Emerging market economies as a whole still track developed economies to some extent A 1% change in developed economies GDP results in a corresponding 0.34% change in overall emerging market economies GDP. Percentage of Global Total 70 60 50 40 30 20 10 0 19901992 1992 1994 1996 1998 2000 2002 2004 2006 2008 08 2010 Developed Markets Emerging Markets Developed economies share of global GDP has declined, but still remains the lion s share of world production. This may continue to diminish, although developed countries GDP as a share of global GDP is likely to remain significant. Diversification of trade dependency is overall a positive development, as it may lessen the potential impact of a single trading partner. On the other hand, it does introduce new risks in the form of exposure to additional economies. In many cases, this exposure may be to other more volatile, developing economies. In addition, as emerging economies decouple, they will no longer benefit as much from the growth and demand for goods from developed countries economies to fuel their growth. These factors can work in both a positive and negative direction depending on the economic cycle of different economies. Source: PNC As noted, there have been instances of decoupling in the past. In the event of an extreme global disruption as we experienced in 2008/2009, it is likely that all economies, both developed and emerging, would be affected to some degree. Also, it is important to remember each emerging economy differs in terms of exposure to developed countries economies. We advise careful analysis and evaluation when investing in developing countries, as they tend to be more volatile and reactive to both domestic and global factors.
4 PNC Investment Perspective The State of the Union Jobs numbers, corporate earnings, new housing starts, interest rates, CPI, GDP the announcements of economic indicators seem endless and often contradictory. Some seem to demonstrate the recovery is steaming ahead, while others seem to imply steps back in terms of progress. It is our intent here to assess how the economy is doing and the implications for the market. As we begin the year, several indicators show the U.S. is continuing to grow, despite some mixed results in corporate earnings and what we feel is a temporary negative impact of an unusually severe winter. We believe that the economy will stay on its path of improvement in 2014. There are a number of factors that have helped to boost net worth, such as jobs regained. 86% of lost jobs recovered Since 2010 Total Nonfarm Payroll Employment (seasonally adjusted) All Employees (thousands) 140,000 138,000 136,000 134,000 132,000 130,000 128,000 126,000 A positive indicator to note is the total net worth data reported for U.S. households and not-for-profit organizations. In early March, the Federal Reserve released net worth data (Oct-Dec 2013), which showed a fourth quarter increase of $2.95 trillion. This figure is up 3.8% from the previous quarter, to a record high of $80.7 trillion. This represents a $21.1 trillion increase from the depths of the recession in 2009, which we view as a strong sign of economic recovery in the U.S. There are a number of factors that have helped to boost net worth, such as jobs regained. Since bottoming out in early 2010, almost 6.0 million of the approximately 7.0 million jobs lost in 124,000 Jan 04 Mar 05 May 06 Jul 07 Source: Bureau of Labor Statistics, Current Employment Statistics Survey, PNC the U.S. have been recovered. We believe this has contributed to the ability to increase financial assets. We also believe that strong stock market returns have also helped boost the value of financial assets. After a negative 37.0% return in 2008, the S&P 500 has experienced positive returns for the past five years, ranging from 2.1% in 2011 to 32.4% in 2013. While the impact will depend on an investor s asset allocation to domestic U.S. large cap stocks, it is likely that the average investor benefited noticeably. Sep 08 Nov 09 Jan 11 Mar 12 S&P has had positive returns for the last 5 years Annual S&P 500 Returns (with dividends) May 13 Year S&P 500 Return 2009 26.5% 2010 15.1% 2011 2.1% 2012 16.0% 2013 32.4% Source: S&P 500, PNC continued on page 5
5 PNC Investment Perspective continued from page 4 As one s residence typically represents a substantial portion of one s net worth, the partial recovery of the residential real estate market has been an aid to net worth. After a rapid descent in prices in 2009, a partial recovery in 2010 and a dip down again in 2011, home prices have risen steadily since then. According to data from Case-Shiller s 20 city index, year-on-year home prices grew 11.3% from December of 2012 to December 2013. Growth in net worth signifies a more robust economic outlook in a few ways. Home prices grew 11.3% December 2012 to December 2013 This increase on the asset side of the balance sheet has allowed individuals to reduce their liabilities. Consumers have paid down home loans, although overall household debt did grow 0.9% in 2013, the highest since 2007. A healthier balance sheet should contribute to increased consumer confidence and encourage consumer spending. Increased spending should boost manufacturing, which benefits employment, corporate earnings and economic growth. S&P 500: Market Days Without A Correction 1/3/1928-1/3/2014 We believe the U.S. economy will continue to expand with slow gains in employment. This is a number we will be watching carefully. It is our view that the Federal Reserve is likely to continue to provide some level of support in order to maintain the upward trajectory of the recovery. Overall, we are encouraged by indications of stronger economic growth for the U.S. We believe that 2014 may show a slightly faster pace of recovery and growth than 2013. In terms of market implications, we believe it is likely that we may experience an increase in volatility for three reasons. In the first place, 2013 Decline 5% 10% 20% Current Case 143 575 1,224 Average 49 161 635 Multiple of Avg. 2.9 3.6 1.9 We believe the U.S. economy will continue to expand with slow gains in employment. was actually a very calm year in terms of volatility, which is often a precursor to a jump in volatility. Secondly, the market has gone for a longer than usual period with a significant downside correction. We view corrections as part of a healthy market, so it is likely the market is due for one. Finally, with the growth in equity values over the past five years, we believe that stocks as measured by the S&P 500 are no longer cheap, but are probably more fairly valued at this point. This also increases the potential for volatility and downside movements. We will maintain a close watch on the markets, but hold a long-term overall positive view. Source: Ned Davis Research, PNC
6 PNC Investment Perspective For more information, please contact your Investment Advisor or Relationship Manager. The material presented in this newsletter is of a general nature and does not constitute the provision by PNC of investment, legal, tax or accounting advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions expressed herein are subject to change without notice. The information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs. For more information, please contact PNC at 1-888-762-6226. The PNC Financial Services Group, Inc. ( PNC ) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services and lending of funds through its subsidiary, PNC Bank, National Association, which is a Member FDIC, and provides certain fiduciary and agency services through PNC Delaware Trust Company. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax or accounting advice. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, or the Federal Reserve Board. Securities involve investment risks, including possible loss of principal. Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value. 2014 The PNC Financial Services Group, Inc. All rights reserved. pnc.com