Paul Diggle

Welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn, and today we are focusing on the cyclical macro outlook for the emerging market complex and in particular growth, inflation and monetary policy dynamics across Latin America, Asia, Central and Eastern Europe. Now, as ever with emerging markets, there are plenty of idiosyncratic and individual drivers and events. But there are also some common themes across EMs, most importantly, a meaningful shift lower in inflation and the tentative beginnings of an interest rate cutting cycle. So joining me in this discussion are Bob Gilhooly who is our Senior Emerging Markets economist. Welcome, Bob.

 

Bob Gilhooly

Thanks, Paul.

 

Paul Diggle

And Michael Langham, our Emerging Markets Analyst. Hey, Michael.

 

Michael Langham

Hi, Paul.

 

Paul Diggle

So Michael, let's start with you then and talk about the growth picture across emerging markets, because there are both some headwinds, but there are also some very resilient economies in EMs. So first of all, where is growth more challenged and why?

 

Michael Langham

So, yeah, we've definitely seen a broad slowing of growth across emerging markets this year. And I think that comes down to a few factors. We've definitely seen a tightening of policy conditions across the board, monetary policy has tightened quite aggressively in places like Latin America and Central and Eastern Europe. So that's definitely weighed on domestic activity. You've also seen fiscal policy, pulling back from that pandemic stimulus. You think of what they're spending on testing and healthcare that's been pulled back, and some of the supportive measures for households and businesses have also been pulled back as well. Another factor would be the squeeze on real incomes from high inflation. I think that's been particularly pertinent in Central and Eastern Europe, which has seen a sharp rise in energy prices when Russia invaded Ukraine. And that's really squeezed real incomes, sent domestic demand slumping, and has also impacted manufacturers’ and businesses’ ability to generate profits. The other factor would be the slowdown in the global goods cycle. And again, it's proving a challenge for those EM exporters in Asia but also Central and Eastern Europe. Where you are seeing emerging markets starting to buck the trend would be the likes of Mexico, which is enjoying spillovers from the strength of the US economy, and seeing high investment there and generally, domestic demand has held up pretty well. Brazil would be another option with its agricultural exports performing well. India’s another place where domestic demand has been really strong. You've seen the service sector really resilient. So as always a bit of a mixed picture with emerging market growth, but resilience in a few bright spots.

 

Paul Diggle

Thanks Michael. So as ever, a mixed picture. There's been a lot of talk all of US resilience versus recession. In that picture you painted of EMs are there any outright recessionary economies amongst the most challenged ones?

 

Michael Langham

Well I’d definitely say you're seeing growth stalling in the likes of Chile and Peru with those monetary tightening cycles really biting on domestic activity there. You've also had some political headwinds, but for outright recessionary-type dynamics, Hungary and Poland stand out to me. Real incomes have really been squeezed, the manufacturing sector has been hit by the energy shock, as well as demand weakness. So CEE is definitely the area where growth has slowed more dramatically, I think that's shown similar dynamics to the eurozone and US differential. There, you're seeing Central and Eastern Europe demand falling quite sharply.

 

Paul Diggle

Great, but as you say, there are also very resilient economies in the EM complex as well, Mexico, India, parts of Asia. But let's move on to the inflation picture, then, because there is a pretty clear step down in rates of both headline and core inflation, across many emerging markets. Give us a sense of how large the decline in inflation has been, and what's been behind it.

 

Michael Langham

Yeah, so you've seen a convergence on the emerging market inflation front. From those high double digits in early 2022, you're now seeing that more in single-digit ranges. Energy and food price base effects have played a major role in that. In year-on-year terms, you're seeing disinflation across most EM regions now since the start of the year. And those lower energy prices have been reflected in reduced import prices, but also reduced producer price, inflation as well. Supply chain normalisation has helped also curb some of the producer price costs, and that's feeding through to softer core goods, inflation. And that's been a real important theme for emerging markets that stickiness we saw in core inflation around March, April time this year, that's actually started to come off. And you're seeing core inflation received both on the goods side, but also the services side, that bit where central banks are particularly focused on that has begun to recede. And that speaks to some of the growth weakness I mentioned earlier, but also just how aggressive we saw the monetary tightening cycles in a lot of EMs. And we're now around, you know core inflation, high-frequency measures are around one percentage point off where they were running pre-pandemic levels. So there's still a bit of a way to go, but that's been a major positive for the EM outlook.

 

Paul Diggle

And what are the most important regional or country differences to pull out in that picture? For example, are there still EMs with particularly entrenched inflation problems? There's also been this notable difference between rates of inflation in Central Eastern Europe, in Latin America and in Asia - so how does that kind of regional difference picture look across the complex?

 

Michael Langham

Yeah, as you mentioned, Latin America and Central and Eastern Europe both saw the largest surges in inflation. So that's coming down now, but Latin America much further ahead in terms of bringing inflation back to target consistent levels. In CEE, you would expect inflation to come down a lot more at the start of the next year - just due to those energy price base effects. But still some way to go in terms of the labour market dynamics being quite tight. And that being a potential threat to this stickiness question we have around inflation dynamics in EMs. Where you've maybe seen a bit of divergence is Asia. Inflation just never really got to those levels that it did in the other two regions. And while it's been a challenge for policymakers, they've not had to tighten as aggressively to bring output back to levels where you can bring inflation down. Maybe that speaks to the staggered re-openings in Asia, but also, you know, governments intervened in places to keep energy and food prices from spiking higher, and that did help to mitigate some of the inflationary pressures we were seeing in the region. I think China is a good example of just how inflation has been quite muted in in the region. Policymakers there clearly seeing what happened in developed markets in terms of how inflation spiked up with demand stimulus, and policy has been a lot more focused on the supply side, which ultimately is increasing capacity and just proving disinflationary. So Asia, bucking the trend a bit, but inflation generally coming down across regions.

 

Paul Diggle

So that's a that's a pretty positive story. But it’s not like there are no risks to the inflation outlook, both in emerging markets, but also globally. So let's talk about some of those that are risks to the disinflationary story because they seem to come from recent commodity price increases from El Nino weather patterns. How much could those derail a pretty encouraging disinflationary trend across emerging markets?

 

Michael Langham

Well, we've already seen food price inflation, posing a challenge to this disinflation narrative in EMs. Korea, the Philippines, and India all recently having inflation upside surprises because of food price spikes. This uncertainty around food prices and supply - it's going to persist. We've got El Nino climate conditions, and that is having an impact on food production. I mean, tomato prices in India spiked 500% in a matter of a couple of months. And those kinds of shocks do present a challenge for policymakers. That uncertainty around the upside surprises on the food component is quite important for emerging market policymakers, given just how much food accounts for CPI baskets across EMs. Going back to India, food and beverages account for around 40% of the CPI basket, Mexico, Philippines, Thailand, are other countries where food inflation can really have an outsized effect on the path for headline inflation. The other obvious commodity that we have to talk about in terms of upside risks, is the recent rise in energy prices. That certainly again, will have, you know, a slowing effect on the disinflation trend that we're seeing across EMs. I think what you have to compare it to is to the shock in terms of energy prices in 2021. Even with this recent uptick in global oil prices, is not going to have the same inflationary shock that it did, you know, two years ago - or a year ago for EMs. So while that may in month-on-month terms slow the disinflation trend across emerging markets, it should in outright set inflation on a different path.

 

Paul Diggle

Bob, let's bring you into the conversation here and talk about China. Michael's done a great job summarising so many of those other emerging markets but we can't talk EM without at least mentioning China. And one of the things that people thought was going to cause upside commodity price pressures earlier this year was China's reopening rebound. That's obviously faded pretty fast. It's not so long ago that we did an episode on challenges in China's real estate market. But what's your latest read of the growth and policy balancing act in China?

 

Bob Gilhooly

Yeah, you know, I've taken a bit of comfort in the fact that the cadence of kind of policy announcements has increased. We also had a somewhat better set of August data coming out and at least on the manufacturing side, the September PMIs that just came out, we're actually reasonably good. And at a minimum, I think it at least kind of counters the notion of an economy somehow in freefall. And again, maybe countering some of the more extreme pessimism that's gripping much of the China comments right now. But, you know, it's still not really clear that the authorities have this growth and policy balancing act right. You know, this cautious approach to stimulus might still be kind of allowing them to hold the line on de-risking. This kind of plethora of relatively small steps to shore up growth risks is I think just doing a bit too little too late, It could allow some more protracted weakness and kind of low inflation to kind of embed in the economy. Both these things are just going to make challenges that they face around fiscal sustainability, particularly at the local government level, more difficult. And clearly weak property is already feeding into local government finances, and also affecting household confidence. Which means, you know, we think household savings amassed over the pandemic are still very much Likely to kind of sit on the sidelines for the moment. So all of which I think implies risks of a hard landing in China have been rising. I think it is kind of fair to call that out. But that said, you know, the policy backdrop is still kind of a self-imposed constraint, for the most part. And the ability to dial up stimulus does make me a bit more sceptical about the most pessimistic commentary out there. You know, we would say the balance of risks are skewed to the downside. But there is, I think, maybe underappreciated upside risk too – as possible recent weakness spurs a more aggressive policy response. And, you know, the National Bureau of Statistics in China might have stopped producing the numbers, but your high youth unemployment could potentially motivate the balance tipping back, but more towards current growth. Social stability can certainly be a trigger for a U-turn, as we saw with the reaction to the zero COVID protests at the end of last year. So, and then a more forceful policy package could potentially unlock the excess savings. And obviously, you can have growth and sentiment snapback. Now, you know, I think there's quite a high bar for this, the probability of that kind of upside scenario does seem low, but given China's opaque governance system, or as I said, rapid policy changes can happen, I still think there is a route to an upside surprise too.

 

Paul Diggle

So plenty of challenges in China's economy, but also a growing policy response, which potentially means that pessimism can be in danger of being overdone when it comes to China's outlook. And work you've done, Bob, suggest that all these incremental policy easing measures actually do add up to something more meaningful. And that actually should start being a positive support to the economy at this point, right?

 

Bob Gilhooly

Yeah, exactly. Hope so. So our financial conditions index has moved from what was a very negative position in 2022, reflecting the difficulty of countering zero COVID and other headwinds from property into one of kind of modest accommodation. And our modelling work also suggests there would be typically around about an eight-month lag between policy becoming accommodative, and then seeing real effects in the economy. And since you know, financial conditions, at least in our estimate, only turned positive around about March this year, it could just be a little bit too early to see some of those kinds of dynamics play out in the economy.

 

Paul Diggle

Michael, let's talk about the start of monetary policy easing in other emerging markets, because some economies have already cut interest rates by surprisingly large amounts in one or two cases. Where's the interest rate cutting cycle already underway? And why are certain EM central banks actually looking to surprise markets in the size of rate cuts?

 

Michael Langham

Well, I think on that last point, EMs have generally done a better job of tackling inflation than their developed market counterparts. We've seen headline inflation recede quite significantly in a number of EMs. And that's allowing central banks to pivot earlier and building up credibility. I think where you've seen that credibility grown most is in Latin America. So a number of central banks there began cutting. I think Uruguay was first but we've seen Chile, Brazil, Peru, and Paraguay. Bigger cuts than expected initially in Chile, and Brazil. But again, that speaks to the credibility built up by the central banks. Markets were already pricing quite significant cuts by both of those central banks, and inflation had receded quite significantly. Growth was also slowing in Chile, which gave the stronger reasoning behind monetary policy cuts of that size. Where I think there was some less credible action, I’d point to Poland - 75 bps against market expectations of 50 bps. There's some concern around what the motivation was, for that larger than expected cut. The central bank having a pro-growth tilt, and with elections coming up, it did feel as though the central bank was maybe leaning on stimulating economic growth ahead of those. So I think you saw that in the market reaction actually, how it differed across those meetings. The zloty sold off quite significantly after that announcement, whereas the real held up, held up better, when the BCB cut. I think that also speaks to where real policy rates were ahead of those meetings. Poland still hasn't really brought down headline inflation near target. It’s in double digits still. So it just again, goes back to that credibility issue. And LatAm certainly, you know, are the front runners in terms of building up the credibility to be able to deliver an easing cycle.

 

Paul Diggle

And you mentioned currencies there, Michael and currency moves are always a particular concern for emerging markets central banks. One of the points you've made in recent EM analysis you put out is, while a broader, emerging market monetary policy easing cycle is coming, it's probably not until next year that the full job of stamping out inflation will be completed and will allow a broader set of emerging markets beyond kind of Latin American leaders, you've mentioned there to be cutting interest rates. So what are the factors that make you think that that pan-EM easing cycle, although coming, has to wait until later in 2024?

 

Michael Langham

Well, as I mentioned, already, we had these food and energy upside surprise risks. That’s certainly keeping some of the more cautious EM central banks on hold. When inflation can jump two percentage points in a month, just on food inflation alone, that will make some of the central banks a bit nervous, particularly if headline inflation isn't yet within target range. But I think the elephant in the room, as always for emerging markets, is what's happening in the US. Fed policy is tight. And we still don't know whether they're fully done on that front yet. But the dollar is strong, and nominal and real yields are rising in the US, which puts pressure on the EM assets. So in the minds of central bankers, they're thinking, well, if we deliver cuts at this point, what would that mean for our currencies when the dollar is this strong? And we've seen that crop up in central bank notes and speeches. Bank Indonesia being one of those which has flagged currency pressures as a concern around the monetary easing cycle. So until inflation has got further along the way in terms of coming down to target consistent levels, I think you're going to see more EM central banks use caution, particularly given inflation surged so high in a number of EMs. Another factor, I would point to is fiscal concerns often underappreciated in this monetary policy tightening cycle, but there is this counter risk that fiscal easing poses to central banks in emerging markets. Certainly, in Brazil, there was a bit of hesitation around cutting initially wanting to see what Lula's fiscal policy was gonna look like before they actually went ahead with easing. In Thailand now you've got this coalition between the runner up and the military announcing quite stimulatory fiscal measures and that's playing into what the Bank of Thailand is having to do - still hiking actually. Mexico's one I’d flag as maybe a central bank that's built up a lot of credibility. But on the fiscal side, you're seeing a shift from quite austere fiscal policy to a more stimulative approach going into the election year. And that, again, posing a challenge for policymakers, which, when the Fed is positioned as it is, and the dollar’s as strong as it is, does warrant caution. We've got a number of EM elections coming up next year. So again, that could create this caution in terms of central bank thinking. But ultimately, I mean, we are we are expecting an easing cycle in 2024 for a lot of them, cutting before the Fed, which I think, speaks to how far EMs have gone in terms of building up credibility. And that's something I think we should recognise as a positive for the emerging market outlook in future cycles as well.

 

Paul Diggle

So I think all that adds up to a cyclical EM macro picture that, while not without his challenges, with plenty of idiosyncratic stories, some of which you've dived into there Michael, is broadly a favourable one - particularly lower inflation, the start of a rate cutting cycle. Bob. A more structural factor that may be benefiting certain emerging market economies, particularly away from China, is the trend towards nearshoring, reshoring, ‘friendshoring’, call it what you will. Tell us what this trend is, where we're seeing it play out, who the potential EM beneficiaries could be.

 

Bob Gilhooly

Yeah, I mean, this, reminds me a little bit of the debate about the internet and productivity, to the extent that we can often kind of see it everywhere except in the macro data - or except in the macro data we want to look at. And I think, you've kind of flagged why this is difficult to see, to try to disentangle the actual outcomes versus counterfactuals, and these kind of cyclical dynamics versus structural trends. So for example, I mean, we would expect the lower value added manufacturing to be relocating out of China over time anyway, as a natural process of China moving up the value chain. So say textiles, in particular, moving to other countries like Bangladesh. I sense there’s a kind of question here about whether investment flows are in effect larger than we would have expected, therefore kind of giving you an indication about an acceleration of reshoring. Or if you're kind of trying to infer reshoring by other macro indicators, such as just the trade flows, well, here it can be very hard to parse out cyclicality in global trade flows, which can disguise these long-run trends. Now, I guess you know, in theory trends and inward FDI (foreign direct investment) should provide the kind of cleanest read on reshoring, as it focuses on those new investment flows. And if you go a bit further back, 2017 onwards, you know, we do see India in particular, taking a larger slice of the inward FDI pie. Indonesia looks fairly strong over the pandemic period too and, you know, FDI flows into LatAm have been a little bit stronger, but maybe not as much as you would have thought. So I think it's actually quite surprising in some respects, the dollar values of Mexican inward investment haven't actually picked up that much in the data, despite all this kind of buzz around nearshoring and friendshoring. Now it could be just that it's too soon to kind of see it in the macro data. FDI data itself is quite lagging. And I just listened to couple of really good podcasts by our colleagues in EM equities, where they kind of discuss some of the on-the-ground evidence on reshoring and what they're seeing at the company level. And, you know, one indication and they're kind of looking more at the details, and if you take Mexico as a pretty good example here, you know, we can potentially kind of a, Mexico clearly being close to the US. So few factors - industrial real estate, investment plus rental prices, and then employment, investment. All of these in the north of Mexico seem to be outperforming other regions. Firms also seem to be reporting that while strength of US demand is still playing a role in driving some of the investment trends within Mexico, new facilities are being set up by Asian companies, motivated by nearshoring considerations and indeed banks including the central bank of Mexico's estimated if you think of this as a kind of pretty broad view of second-round effects, it could be up to about 16% of firms kind of indirectly benefiting from these nearshoring trends going on. And for what it's worth, the Mexican government says there are about 400 firms investing in Mexico due to nearshoring. We have certainly had some high-profile announcements, particularly centred on autos. So, Tesla’s reportedly going to invest 5 billion US dollars. Again, we need to be a little bit careful here. It's possible that some of the tighter rules, the rules of origin imposed by USMCA on the auto sector are driving this, but you know, overall, US-China tensions, plus the kind of pandemic-induced supply chain stress, I think, do seem to be leading to a kind of reconsideration of where firms want to be on this kind of efficiency through to resilience spectrum. And both seem, you know, highly plausible reasons why EM Ex-China will continue to kind of or should be benefiting from reshoring. But perhaps if you're waiting to see it in the macro data, you might be waiting a while longer.

 

Paul Diggle

Thank you, Bob. Well, that's about all we have time for today. Thank you to Michael and Bob for your insights. And thank you too for listening. As ever, please like and subscribe to Macro Bytes on your podcast platform of choice. But until next time, goodbye and good luck out there.

 

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