As the global economy slowly recovers from Covid, emerging markets (EMs) will have to deal with not only their own domestic pressures arising from Covid, e.g. rapid increases in inflation due to disrupted supply, a rise in demand as economies slowly recover and soaring food and energy prices, but the consequent effects of developed markets becoming more sensitive to supply chain concentration and new thinking on the utilisation of domestic industrial policies.
Globally continuing supply chain disruptions, labour shortages, and the ongoing battle against Covid-19 and its many variants is creating great uncertainty for policymakers and investors. And, unfortunately, we know this is not going to be the last global pandemic that developed and emerging markets have to deal with. The effects of climate change including changing weather patterns, increasing frequency of extreme weather events and rising biodiversity and habitat loss will inevitably lead to further zoonotic and human-transmitted pandemics. As noted by the OECD in their September 2021 Economic Outlook Interim Report, “although global GDP has now risen above its pre-pandemic level, the recovery remains uneven with countries emerging from the crisis facing different challenges.” Regardless of how quickly emerging markets are able to get a handle on the Covid pandemic, it is becoming clearer that one area that will continue to be hit will be trade.
Ships, trains, planes and automobiles
Trade patterns were already changing before COVID due to rising protectionism in the form of tariffs and local content requirements. These issues have only been exacerbated by growing concerns about the permanency of supply chain disturbances and associated price rises coming from soaring raw material costs, shortages of shipping containers, and long delays at ports.
Shipping costs have grown significantly since Autumn 2020. The Baltic Dry Index, which tracks shipping rates for dry commodities, is up by about 170% this year. The competition for ocean freight capacity has intensified as economies open up further, there is rising global demand and inventories are rebuilt across supply chains. In the short to medium term, shipping rates are likely to remain high due to limited increases in shipping capacity and the disruptive effects of local lockdowns. Although companies are reported to have looked to other sources, e.g. passenger jet holds, charting ships directly, cross regional trains, and trucking, none of these has proven particularly successful in shifting goods in the time and to the degree needed. All of this is undoubtedly contributing to changes in the “just in time” mentality that dominated international industrial activities and planning since it was first introduced in the 1970s by Toyota. This is reflected by the growing political pressures in developed countries in the form of industrial policies whereby governments are focusing on more national self-reliance and export controls for key goods and materials. Governments will remain focused on domestic job creation, especially once debt financed fiscal handouts have stopped and furloughs are ended.
The supply constraints have, as noted by UNCTAD in its May 2021 trade update, “created substantial uncertainty into the operations of many global value chains, providing incentives to scale down segmentation and shift production closer to consumers (reshoring and nearshoring). The continued development and implementation of regional trade agreements (e.g. RCEP and AfCFTA) and ongoing trade tensions between major economies could also contribute to changes in production patterns of global value chains. Moreover, container shortages and increasing freight rates could provide further impetus for reshoring and nearshoring trends. means that companies are now seeking to re-shore or at least reduce the concentration of their supply chains.” Much will depend on how quickly supply constraints can be resolved; it is looking increasingly unlikely that shipping and other transportation methods will be at pre-pandemic levels before Spring 2022.
What does it all mean for emerging markets?
When investors think of EMs, they generally think first of China. Prior to the pandemic, there had been growing concerns by investors over China’s increasingly tense trading relationships with neighbours such as Australia and the political back and forth with the US. In addition, China’s growing labour costs, the high concentration of inputs from China into all types of products, and the bottlenecks in shipping from China caused concern. The growing threat of a credit crunch due to a potential fall in interbank lending in China following the collapse of Evergrande and limitations on electricity usage to meet specific requirements to reduce energy and emissions will likely entail a slowdown in the rate of economic growth as production and exports slow in 2022 and beyond. These growing expectations of slower growth may explain the negative impact on asset prices outside of China. Ratings agency S&P on 27 September lowered its annual 2021 GDP growth forecast for the Asia Pacific region to 6.7% from 7.1%. It seems that the world has come to depend on Chinese demand. A weaker Chinese economy moving forward will mean weaker exports to China, particularly for emerging markets that are dependent upon Chinese commodity demand.
From a global perspective, although global trade did recover in early 2021, this was primarily due to the strong export performance of East Asian economies which have since been, as noted by the Asian Development Bank (ADB) in their Asian Development Outlook (ADO) 2021 Update, subject to waves of Covid,-19 variants, renewed local outbreaks, the reinstatement of various levels of restrictions and lockdowns, and slow and uneven vaccine rollouts, all of which, have been disrupting trade. In terms of commodity demand, the story for EMs is mixed. Some EMs should benefit from rising gas prices as they will generate significant cash flows for oil-focused producers who are already benefiting from higher oil prices in 2021. Those EMs dependent on energy imports, e.g, South Africa, will feel the pinch on growth.
But it is not all doom and gloom for EMs. What matters more than a growth slowdown in China (and the consequent effect it would have on some commodity prices) is the policy reaction from EM governments. This includes improving vaccination rates to increase mobility measures and avoid renewed restrictions which will help service sector recovery as well as boost domestic consumption measures. As noted by S&P in its 27 September update, merchandise trade will continue to support growth in the EMs in the coming quarters as inventory restocking continues in advanced economies. However this will likely moderate back to trade related services.
Although many EM fiscal positions have weakened significantly during the pandemic, and it will be politically difficult to make fiscal adjustments by removing stimulus support, it may be the best tool to make their fiscal accounts sustainable and consequently reduce or stabilise their debt ratios. EMs central banks will have to walk a fine line in managing inflationary expectations. The reaction of central banks to rising inflationary pressures will also be critical to currency strength; this impact will be felt in sovereign bond markets, corporate bond markets and will impact the liquidity available to companies. However, given the higher real yields and improved external balances we have seen in some EMs, there are still some good opportunities for investors if they look closely at the conditions in each EM.