During the past decade, emerging markets have grown strongly and a lot of capital has flown into the emerging markets world. Additionally, as EM have a high commodity intensity of growth, the demand for commodities increased significantly. Coupled with low growth in commodity supply, this lead to the commodities super-cycle. However, higher commodity prices put upward pressure on European (ex Norway) and US inflation and downward pressure on growth. Thereby, it worsened the debt crisis of recent years and lead to more capital flowing out of Europe/the US into EMs and commodity producers. Last year, however, this process went into reverse. The fundamental environment for a large number of Emerging Markets and commodity producing economies has been deteriorating amid the build up in (private sector) indebtedness, loss of competitiveness, rising current account deficits/falling surpluses and growing political risks. The fundamental supply-demand balance for commodities has deteriorated as well amid higher supply growth on the back of the previous rise in investment and lower demand growth due to weaker growth in the commodity intensive emerging markets. On the other side, systemic risks in the Eurozone have receded, real growth in Europe and the US is slowly rising and QE draws to an end, leading to upward pressure on UST, Gilt and to a lesser extent Bund yields.
Developed markets and commodities: From a vicious to a virtuous cycle
Source: ResearchAhead
In turn, capital
has started to flow back out of EMs and commodity producers into Europe and the
US, leading to strong upward pressure on currencies such as EUR, GBP and USD. Thereby,
the previous vicious cycle has given way to a virtuous cycle. Commodity prices
have stopped rising/been dropping. This puts downward pressure on inflation but
supports real growth. This in turn, eases the debt crisis and helps to improve
fiscal budgets. This process has much further to run and the trends of recent
quarters where DM assets outperform vs. EM assets - with EUR, GBP, USD
appreciation vs. a broad basket of currencies, EM vs. DM spread widening and DM
equity market outperformance – can continue. While the appreciation in EUR, GBP
and USD acts to tighten monetary conditions, it also props up asset prices and
provides for an improvement in financing conditions – especially in the
Eurozone periphery – which constitutes a loosening of monetary conditions. Just as EM equity markets dropped significantly in
recent months, DM equity markets moved higher. Furthermore, as the chart below shows, sovereign CDS in
Europe and the US fell sharply while sovereign CDS in emerging markets rose
significantly.
12m change in 5-year sovereign CDS
Source: Bloomberg
Moreover, the export environment should improve despite the stronger
Euro and a more challenging environment for emerging markets and some commodity
producers. The table below shows exports in % of GDP for Eurozone countries. The
first row shows exports going to other Eurozone countries, the UK, Switzerland,
Sweden, Denmark (i.e. Western Europe ex Norway) and the US. The second row contains
exports relative to GDP going to Emerging and Developing countries. The final
row shows the ratio of the two numbers. Exports to Western Europe and the US
far outweigh those going into the EM world. The Euro did not appreciate much
vs. these currencies (it even depreciated slightly vs. CHF and GBP). Only in
the case of the USD has it appreciated meaningfully over the past year. However,
with a rise of approx. 6% this should not be enough to negate rising demand on
the back of higher US growth. In turn, export demand for Eurozone countries
(and the UK) should improve given that they are mostly dependent on each other,
thereby mutually reinforcing their cyclical upswing!
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