Media headlines have been dominated by the political and economic travails of Greece over recent weeks, as analysts and economists debate the likelihood of a Greek exit from the eurozone and its potential implications.
However, we believe that investors’ focus on the situation in Greece is distracting them from a more important and possibly more dangerous trend occurring in the global economy.
Across the countries of the emerging world, manufacturing and trade activity is slowing very rapidly. In countries as diverse as Taiwan, Brazil, India and South Africa, industrial production is now declining year-on-year. In Korea, Russia, Mexico and Turkey, industrial production growth remains positive on a year-on-year basis, but the rate of growth has slowed significantly over the last few months and is now below 3.5% year-on-year in each of the four countries.
In China, although the official series shows production growing at 9.3% year-on-year, electricity consumption data and rail freight volumes tell a significantly different story, having slowed to a growth rate of 1.5% and 3.3% respectively. Taken together, these indicators suggest a broad-based decline in manufacturing activity across the emerging market universe that risks deepening into outright recession.
Asian export data, which normally provide a leading indicator of global supply chain activity, show similarly concerning trends. Korean and Taiwanese exports have weakened sharply over the past three months and are now declining year-on-year. Chinese exports and imports have also declined sharply.
While investors and economists often like to focus on the growth in the service sectors of emerging markets economies, industrial production has very high importance in low-income developing economies. By providing jobs and export earnings, manufacturing activity plays a crucial role in consumption growth and domestic service sector development. Thriving assembly and export sectors have been an important driver for almost all successful emerging market economies. Conversely, emerging market economies which experience declining exports due to loss of competitiveness or demand factors become rapidly dependent on foreign capital to sustain consumption. This makes them extremely vulnerable to any confidence shock or cessation in global capital flows. This dynamic has been a key factor in economic crises from the Asian crisis in 1997 and the Russian crisis in 1998 onwards.
Leading indicators of overall GDP growth in the second quarter suggest that the slowdown in manufacturing is indeed having a significantly depressing effect on economic output in emerging markets. GDP growth estimates for major emerging market economies such as Brazil, India and China are being revised significantly downwards. We believe that India may grow by less than 4% this year. Brazil may struggle to record 3% GDP growth. China could grow by less than 5%, although the officially announced GDP number will likely be higher, as in 2008 when China reported an official GDP growth rate completely at odds with all other activity indicators, due to the Chinese Communist Party’s acute sensitivity to reported economic growth rates.
Beyond emerging markets, the significant slowdown in manufacturing activity is also clear in European economies. Eurozone PMIs have tumbled from close to 50, the boundary between growth and recession, in the first quarter of this year to a current level of 45.9, suggesting a significant downshift in manufacturing that will continue over the coming months. Even in Germany, the manufacturing PMI index has fallen to 46.2, a level not seen since the fourth quarter of 2008 and indicative of significant contraction. The sharp decline in manufacturing activity in Europe’s erstwhile powerhouse economy suggests that what is happening is not “merely” the effect of Greece’s turmoil, since Greece accounts for less than 2% of European Union GDP, but a more broad-based decline, driven by global trade links and supply chains.
For now, the US remains an exception to this weakening global trend. In contrast to the rest of the world, there has been no sign of significant slowdown in US manufacturing, either on an activity or PMI basis. Manufacturing sentiment remains much stronger than global peers, with the ISM business sentiment survey at 54.8, and industrial production continues to grow at a very strong 5.2% year-on-year rate. However, readings from regional business confidence surveys are confusingly inconsistent and the rate of expansion in business payrolls has dropped sharply. These indicators may signal a weakening in industrial output. Investors should watch US data very carefully over the coming weeks, particularly with regard to business confidence surveys and activity measures. Any sign that the strength in the US manufacturing sector is fading will significantly increase concerns that global manufacturing is entering an outright recession, with dangerous implications for the global economy as a whole.
While Greece’s turmoil is dominating the headlines, investors should be at least as concerned about the recent decline in global industrial activity and trade. The financial market disruption that would be caused by a Greek banking crisis or Greece’s departure from the Eurozone would be considerably more toxic if set in an environment where global manufacturing and trade were already in decline. Additionally, policy-makers have fewer tools available to them now than they did in 2008. China is in the middle of a leadership transition and would be unlikely to launch a massive fiscal stimulus as it did in 2008. The US and the Eurozone have considerably more divided political environments than they did in 2008 and in both blocs there are sizeable camps that strongly oppose any further central bank intervention. The level of government debt is substantially higher in many countries now than in 2008, restraining any appetite for fiscal stimulus. Appetite for structural reforms in emerging market countries that need it, such as Brazil and India, has declined rather than increased over the last three years.
Dark clouds are gathering in the distance while investors’ attention is focused on the Greek tragedy playing out on stage in front of them. The global economy may be entering a new and more dangerous period.
Eoghan Flanagan is head of emerging markets at Liontrust.