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A new problem region

A couple of years ago, the Federal Reserve’s interest-rate turnaround would have hit the Eurozone the hardest. This is no longer the case. The emerging markets now appear likely to be the main trouble spot.

In Brief

  • - The global economy remains on a moderate growth path.

  • - Lackluster growth in the emerging markets hampers global growth.

  • - Commodity-exporting countries suffer from low commodity prices.

  • - The United States continues to lead the developed economies’ recovery.

  • - The first rate hike by the Fed is in sight.

  • - The economic environment limits the scope for better earnings to boost equities.

  • - International bond markets may suffer from rising U.S. rates.

" Only a couple of years ago, the Eurozone was the global headache. This is no longer the case. Risks are now centered on the emerging markets. "

A new problem region

Global growth dynamics have started to converge. While economic growth should accelerate only moderately in the developed economies, economic momentum is dwindling in some emerging markets. A general slowdown in these economies will contribute to the flattening of overall global economic growth, although emerging markets will continue to grow faster than still-sluggish developed markets. A return to higher rates of growth, as prevailed before the financial crisis, is not in sight. Even China, until recently seen as the new powerhouse of the world economy, can no longer contribute to global growth in the same way it did in the past.

Emerging markets have come under pressure from various factors. First, worse economic dynamics in the industrialized countries than before the financial crisis impede emerging markets’ exports to the industrialized countries. Second, slower growth in China results in a slower growth in demand for commodities. Commodity prices have therefore tumbled, which in turn hurts commodity-exporting emerging markets. Third, the private sector in the emerging markets has used the low-rate environment in the past few years to borrow money in foreign currencies for investment. But U.S.-dollar appreciation has increased the burden of servicing this foreign-currency debt in local-currency terms. Debt-service problems would be further exacerbated, were U.S. interest rates and the U.S. dollar to continue to rise.

Change of real gross domestic product

Gentle pace
The positive contribution to growth by emerging markets in 2008 and 2009 prevented the world economy from sliding into recession. But these countries’ economic dynamism has faded in the last few years.

The market generally expects the Fed to raise official rates during 2016 in several small steps. The U.S. unemployment rate has fallen from 10% in October 2009 to 5.1% in August 2015, reaching a level where the Fed has to expect the inflation rate to accelerate. Higher employment, hand in hand with moderately rising wages, should boost consumer expenditure. Positive wealth effects in the wake of rising house prices have additionally brightened consumer sentiment. Increasingly stable U.S. economic growth should encourage the Fed to strive for a slow normalization of its still extremely accommodative monetary policy in the next twelve months.

Fed remains cautious

The Fed is likely, however, to proceed in slow and small steps. Inflation remains at a very low level so that inflationary risks are limited. Low commodity prices also help to keep inflation at bay. We expect the federal funds rate to increase in several steps to 0.75-1.00% by September 2016 – a level which would still be well below our 2016 inflation-rate expectation of 1.6%.1 An additional argument against a larger interest-rate rise is provided by the Fed’s fears about the implications of a stronger U.S. dollar, which would hamper U.S. exports.

Continued negative real official rates are a clear indication of a rupture in the growth trend in the United States and other industrial economies in 2008. The U.S. economy is growing by less than its potential – creating a so-called output gap – but at least it has found its way back to positive growth. The Eurozone and Japan, in contrast, have only just recovered to the economic output levels achieved before the crisis. A trend which had already started in the run-up to the crisis has therefore been continued and confirmed: an increasing growth differential between the United States on the one side and the Eurozone and Japan on the other.

Actual and potential gross domestic product (GDP) in the United States

Growth gap
The U.S. economy returned to a solid growth path after the financial crisis. However, the output gap, which had widened during the financial crisis, could not be completely closed.

Lower growth in the Eurozone than in the United States is the result of austerity measures taken in the last few years. Periphery countries have had to cut their public spending and their budget deficits. This has resulted in weak demand, slowing down growth all over the Eurozone. But the negative effect from this is now fading. Positive effects such as falling levels of unemployment since 2012, moderately rising wages and the depreciation of the euro are starting to play a more significant role. Consumer expenditure and export revenues are therefore set to rise moderately.

Ultra-expansionary monetary policy in the Eurozone

Deflationary risks have thus decreased. However, the 2% inflation target of the European Central Bank (ECB) is still some way off. Inflation has been dampened down by low commodity prices, which by increasing disposable incomes should boost economic growth. Low inflation has, at the same time, encouraged the ECB to think about an expansion and prolongation of its quantitative easing program, i.e. the purchase of government and corporate bonds. The main reason the ECB strives to keep bond rates low is to encourage the financial sector to provide more loans to corporations on favorable terms.

Development of real GDP

Different paces of growth
The U.S. economy is taking the lead, with the other two major industrial regions lagging behind. Further structural reforms are necessary to enable the Eurozone and Japan to close the growth gap; at present, regulations in both regions hold back growth.

Development of consumer prices

Differences in inflation
If an economy grows, consumer prices tend to rise as well. Growth-enhancing structural reforms should therefore also eventually result in higher inflation in Japan and the Eurozone.

The Bank of Japan (BOJ) should also continue its asset purchases. The consumption-tax hike effective from April 1, 2014 caused a slump in growth, from which the Japanese economy has not yet fully recovered. Low money-market and bond rates led to a significant depreciation of the yen from September 2012 onwards, boosting exports. This effect is fading now. Weaker growth in important Asian markets for Japanese goods – most importantly China – currently impedes Japan’s exports. The weak yen additionally dampens consumer sentiment.

Roughly one third of Japan’s population consists of old-age pensioners. This group as well as working-age employees are afraid of losing purchasing power at constant income levels, if the yen continues to depreciate. Consumer spending is therefore set to decrease. This and lower commodity prices should keep the Japanese inflation rate in 2015 at around 0.7%.2 The BOJ’s inflation target of 2% is thus still far off. Japan’s central bank might therefore expand its asset purchases further.

The new heavyweights

In the last two decades, emerging markets have greatly gained in importance due to their above-average growth. The flagship for this development has been China, with a share in global GDP of 13% in 2014 (in U.S.-dollar terms). The other economic giants in Asia, Latin America and Eastern Europe are much smaller by comparison, although their contribution to the global output of goods and services has meanwhile become significant, too.

This period of strong and dynamic growth is, however, fading away. Due to the rather sluggish recovery in the industrial world going hand in hand with decelerating growth in the more important emerging markets, we have reduced our global growth forecast for 2015 by 0.3 percentage points to 3.2%.2 Emerging markets are expected to grow by 4.2% in 2015, with only a slight acceleration in growth in 2016.2 According to data from the International Monetary Fund (IMF), Asian emerging markets grew by an annual average rate of 7.9% between 2000 and 2014. The IMF believes that growth here could slow to just 6.5% over the 2015-2020 period.3

Share of global GDP

The global economic regions
In U.S.-dollar terms, the United States remains the major economic region, followed by the Eurozone. China accounts for a 13% share of global GDP. Measured in terms of purchasing-power parities, however, China’s share of GDP is higher. Lower Chinese wages bring down the price level of non-tradable goods, boosting GDP adjusted for consumers’ purchasing power.

Share of emerging markets in GDP

A glance at emerging markets
China is predominant among emerging markets with a 34% share of emerging markets’ GDP in U.S.-dollar terms. Since trade links between emerging markets have increased in the last few years, economic growth in other emerging markets is being pulled down by decelerating growth in China.

The pace of emerging-market growth has started to fade. This development is epitomized by their economic heavyweight, China, which is expected to grow by a “meager” 6.8% and 6.0% in 2015 and 2016 respectively.4 Over-capacity in many sectors is leading to lower investment growth. The fiscal policy pursued by the Chinese government is rather restrictive. Consumer spending has however risen in recent years due to substantial wage increases. Since the debt level of private households is low, the savings rate is gently falling and available income is rising, consumption should remain a pillar of growth this and next year.

Negative feedback effects

But these wage increases have eroded China’s competitive advantage. As a result, exports no longer act as a driver of growth. Moreover, slower demand growth in the emerging markets has a corresponding negative feedback effect on trade between these countries – something that has become increasingly significant in recent years.

Commodity-exporting emerging markets have been hit particularly hard. Firmly believing that high growth would continue, these countries had strongly expanded their mining and extraction capacities. But from mid-2013 onwards, commodity prices collapsed. Countries such as Brazil and Russia, which are heavily dependent on commodity exports, are already in recession. This may start to bottom out next year but is not over yet.

In order to return to higher growth levels, emerging markets cannot escape economic reforms. Property rights must be promoted, private corporations must be granted more leeway to operate and access to loans must be improved. Commodity-exporting countries must further increase their efforts to diversify in order to achieve economic stability. Structural reforms would also help to attract foreign direct investment (FDI) again to modernize and expand business in many emerging markets.

But this will need time. Further market volatility is possible because many EM corporations used the low interest-rate environment of the past few years to borrow money, thereby sharply raising their debt. An appreciating U.S. dollar and rising interest rates should increase the interest and principal payments due on foreign loans. Rising defaults cannot be ruled out, additionally impeding the economic development of emerging markets.

Emerging-market debt

Rising private debt
Increasing capital expenditure has helped to keep emerging markets on track during and after the financial crisis. The flip-side of this has been rising private-sector debt. Decelerating growth in the emerging markets moreover indicates that some investment has been misallocated.

Foreign debt of emerging markets

Lower foreign dependence
The Asia crisis of 1997 showed how dangerous debt denominated in foreign currencies can be. The devaluation of local currencies increased the value of this foreign denominated debt. From 2000 onwards, emerging markets have reduced their foreign debt as a ratio of gross domestic product, helped by the establishment and expansion of a local financial sector, flexible exchange-rate systems and more balanced current accounts.

The combination of lower growth dynamics and higher debt risk in the corporate sector caused the MSCI Emerging Markets Index to trade sideways for several years. One of the triggers for the emerging markets’ recent slide was China’s decision to moderately devalue the renminbi versus the U.S. dollar. Many investors regarded this step as an implicit admission of slower economic growth by the Chinese government.

Devaluation fuels fears

At the same time, this step increased fears that further devaluations would be used by the government to restore China’s competitiveness. This might enable China to regain economic strength via its export sector, but it would, at the same time, hurt competing companies in other economies. Many of these companies are headquartered in emerging markets. This is likely to have contributed to the strong setback of the MSCI Emerging Markets Index. In mid-August, China’s central bank allowed some days of greater intraday volatility inside the daily fixing band against the U.S. dollar before resuming to manage the currency valuation and volatility again.

China’s government was surprised by the sharpness of the market reaction to this change. Premier Li Keqiang tried to reassure markets that China’s transformation from an export-oriented economy towards a more domestic-consumption-based economic model would continue. Strikingly, the MSCI Emerging Markets Index was hit harder by the renminbi devaluation than the MSCI World Index. This suggests that China’s transformation might have a greater effect on EM corporations than on industrial economies’ firms. China’s devaluation could thus increase the pressure on other Asian central banks to depreciate their currencies.

Development of the MSCI Indices

Industrialized countries versus emerging markets
MSCI Emerging Markets Index buoyancy started to wane from mid-2011, while the MSCI World Index, comprising stocks from developed economies, continued to trend upwards. This emerging-markets downturn was worsened by slow progress on reforms and inefficiently-allocated investment in many countries. Some countries such as China, India and Mexico have already started to implement reforms.

Development of corporate profits

A glance at earnings
From 2011 onwards, corporate earnings developed in quite a similar way as stock-market indices. Emerging-market corporations’ earnings started to come under pressure at the end of 2011. Industrialized-countries corporations, which are represented in the MSCI World Index, maintained and even increased their earnings after mid-2011.

A glance at the bond markets

The renminbi devaluation, worsening economic dynamics in the emerging markets, falling commodity prices and stock-market volatility were factors leading the Fed to postpone its first rate hike. Moreover, U.S. exports have been hurt by the stronger U.S. dollar. Since current economic growth rates are moderate and the economic recovery may not yet be as well-embedded as desired, the Fed is likely to opt for gentle upward moves in interest rates.

Before any interest-rate move, the Fed will closely observe developments in the U.S. labor market, the pace of growth and inflation as well as in capital markets. The Fed stressed at its last meeting that the deceleration of growth in emerging markets would be considered when making a decision on interest rates. Thus, it has become more unlikely that rates will increase markedly on the bond markets.

Since the debt level as a ratio of GDP is high in the industrialized countries, a significant rise in interest rates would particularly burden governments, but also cause difficulties for corporations and private households and weaken economies. Interest-rate levels are not likely to reach those observed during previous recovery phases.

The development of debt

Rising public debt
In the industrialized countries, governments have markedly raised their debt in relation to GDP. Reasons are higher welfare payments in the wake of the financial crisis and state incentives to boost growth. High indebtedness should limit the rise of interest rates in the developed economies.

The development of debt in Germany

Receding private-sector debt
In Germany, the financial crisis also caused the ratio of government debt to GDP to rise from 2008 onwards, whereas debt ratios for corporations and private households fell. In total, debt in 2014 amounted to roughly 185% of GDP – a low ratio compared to the United States or Japan.

A glance at the equity markets

The turnaround in interest rates is likely to make markets somewhat bumpier for investors. But history shows that the positive upwards trend continues after the first rate hike, although setbacks become more likely. Equities are still among the most favored asset classes in this environment. After all, the reason for a rate hike is economic recovery – and the corporate sector should benefit from this.

The forthcoming monetary tightening cycle could, however, follow another pattern. This time, the Fed is likely to hike rates at an even gentler pace than in previous cycles. Because the total rate increase is likely to be small, the downside price risks to bonds should be limited. The winners from a continuing low level of rates are equities, which may offer attractive dividend yields.

Given the recent severe market correction developed markets should offer double-digit return upside over the next 12 months from here, driven by all levers, i.e. earnings growth, multiple expansion and dividends. However, we acknowledge that in the near term growth concerns will dominate and it might take time for the market to share our constructive conclusions.


1 Deutsche AWM forecast as of 9/21/15


2 Deutsche AWM forecast as of 9/21/15


3 International Monetary Fund: World Economic Outlook, as of 04/2015


4 Deutsche AWM forecast as of 9/21/15

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