We are not EM bulls, to put it mildly, and have not been for nearly three years now, but for the first time in three years we can envisage a scenario in which a process of catharsis over the next 12-18 months may make things sufficiently worse so they can then get better.
* The story so far: India, Indonesia, Mexico and Taiwan have passed the point of inflexion away from their old models of growth. Progress is slow elsewhere and broken growth models remain in place (particularly in Brazil, Russia, South Africa and even Turkey), while China needs to deal with PPI deflation and deleveraging alongside ongoing reforms and the transition to a consumer economy. Fundamentals don’t yet warrant a call for a secular bull run in EM markets. Markets offer only a ‘pick your spots’ strategy (China and India equities; Asia investment grade credit; some pockets of local currency debt), not a generalised one.
* What would make us EM bulls? Calling for a secular bull run across asset classes needs a catharsis of EM balance sheets and drags on growth. Post-catharsis trend growth could well be lower, but of higher quality.
* Will the EM macro adjust? On the growth side, there has not been enough adjustment so far. We believe that economies like Brazil, Russia, South Africa and Turkey with EM-like drags on growth (inflation, external exposure) will respond more to the dynamics we describe below than the ones like China and Korea with DM-like drags on growth (deflation, debt) – though both have different dynamics. Whether China adjusts at least partly and sooner will be key.
* While a 1997/98 type crisis is not our base case, a combination of further US dollar strength ahead of a Fed rate hike, a continued deflationary shock from slowing investment spending in China and weakening EM credit growth could generate the necessary catharsis. A strong adjustment from the EM-like group and a partial one from the DM-like group according to our signposts can clean out EM balance sheets and deliver a new model of growth. Should this play out, EM asset prices could start a secular bull run from lower absolute and relative valuation levels than today.