London, 28 October 2009 

GDP growth in emerging markets is likely to outpace that of developed economies over the coming quarters. This, in turn, should ensure that emerging equities continue to outperform high-income country stocks, according to Capital Economics. 

"Somewhat paradoxically, given the comparatively poor economic outlook, equities in Emerging Europe have most scope to surprise on the upside."

• Over the past week we have published both our Q4 Global Economic Outlook in which we presented updated macro economic forecasts for the world economy and our Q4 Capital Markets Analyst in which we updated our view on global markets.

• There are two key points from the Global Economic Outlook. First, we expect a strong GDP upswing in the US over the next few quarters, on the turn in the inventory cycle and the continued impetus from stimulus policies. This will then be followed by a period of weaker growth from around mid-2010 as consumer spending struggles to gain traction once stimulus measures are withdrawn. In Europe, the upswing is likely to be more of a slow grind but even here the worst is probably now in the past.

• Second, GDP growth in emerging markets in 2010-11 is expected to follow a similar trajectory to growth in the US but the acceleration period over the next few quarters should be even stronger, while the slowdown period later next year should be shallower.

• There are also two key points from the Capital Markets Analyst. First, risk markets are likely to move higher over the coming months as stimulus policies remain in place. Admittedly, the risk rally looks mature, the best returns have now passed and valuations are no longer cheap. But, second, it is probable that risk appetite will taper off rather than collapse. Accordingly, capital flows should continue into emerging markets, where returns will probably beat high-income countries and where the risks are either low or are well-known.

• That said, the relative strength of emerging markets as a whole masks a wide variation in regional performance. Asia should continue to lead the way (see Chart 1) on lingering support from stimulatory policies, the increased importance of domestic demand in driving economic growth, and the regional leverage on what is happening in China. China’s GDP growth has likely peaked in q/q terms but any slowdown should be modest in 2010-11 as the benefits from this year’s surge in loan growth keep coming through. The pulling back of China’s stimulus is also likely to be gentle if, as we expect, inflation stays low.

• Countries elsewhere in Asia are more capacity constrained. Therefore, rebounding GDP growth will lift inflation sooner and will bring a more severe tightening of monetary policies. But interest rates will be moving up from historically low levels and it will take a long time for rates to reach the “neutral” levels where they would potentially start to inhibit the upswing. Moreover, low government debt levels mean that any bond market pressure for a draconian fiscal tightening should be small. Finally, we also expect some pull back in commodity prices next year and this would be helpful for Asia too. Nevertheless, the best of Asia’s economic upswing may have already come through or will come through over the next few quarters. Furthermore, the recovery will slow during the course of 2010 and in 2011.

• In Latin America, a number of countries also look set to grow at a healthy clip over the coming quarters, fuelled by recovery in the US, the pick-up in commodity prices, and robust capital inflows. At a country level, Brazil, Peru and Chile should outperform – all three could grow by 5% next year.

• But after an initial bounce, we fear that the pace of growth will fade over the second half of 2010 and into 2011 as the recovery in the US and other high-income countries falters and commodity prices fall back. Moreover, a less supportive global backdrop would also raise concerns about Latin America’s traditional vulnerabilities, meaning that capital inflows could well pull back more severely here than is likely to be the case in Asia. Argentina and Venezuela remain the most exposed to a deterioration in the external environment, while a drop in oil prices is likely to highlight long-standing frailties in Mexico’ public finances. Nevertheless, it is probable that regional growth will slow rather than collapse, we forecast from 4% in 2010 to 2.5% in 2011, but still far better than a likely 3.0% GDP decline in 2009.

• Meanwhile, Eastern Europe will continue to lag behind the rest of the emerging world, although even here the worst is probably now in the past. A combination of still fragile banking sectors, a tightening of fiscal policy and a more sluggish recovery in the euro-zone (the region’s major trading partner) means that regional growth will struggle to top 1% next year. There are also large downside risks to even this sober outlook. Russia is particularly vulnerable to a drop in the oil price. Furthermore, we view a devaluation in Latvia as being more likely than not. Inevitably a de-pegging in Latvia would trigger a currency collapse in other Baltic states but we expect that any contagion elsewhere in Emerging Europe, beyond the short term, would be modest.

• From a valuations perspective, the price/earnings ratio of emerging equities tends to rise relative to that of developed markets during the good times, only to fall back during the bad times, as in 2008.

However, unlike at the peak of the credit boom, the relative price/earnings ratio in emerging markets does not now look particularly expensive. (See Chart 2.) Accordingly, there is scope for relative valuations to shift even further in favour of emerging markets as investors in high-income countries seek out better returns. But compelling valuation is hard to find now in Asia where 12m trailing P/E ratios are generally around 20 or higher (and over 30 in China). Valuations in Latin America are more attractive than in Asia but are reasonable rather than cheap. The equity markets that could potentially perform best are in Emerging Europe. P/E ratios there are still generally below 10 and have most scope to move up. The high economic risks are, for the most part, likely to bring a wild ride rather than big market falls.

• The biggest risk to this outlook is that asset price bubbles develop soon, and then go bust. While this fear is not entirely unjustified – particularly in regard to China and some equity markets in Latin America – our central view remains that emerging equities, while being volatile, will generally drift higher over the next few quarters before then falling back from around mid-2010. Accordingly, we expect emerging equities to end 2010 at lower levels than are likely to be hit over the next six months or so.

Ends --

For forecasts see:

www.capitaleconomics.com