Macro Freestyle – Can emerging markets weather the oil shock?

Hello, I'm Eric Robertson, Global Head of Research and Chief Strategist at Standard Chartered. And I'm Madhur Jha, Global Economist and Head of Thematic Research also here at Standard Chartered. Welcome to Macro Freestyle, our monthly podcast series where Madhur and I will identify and explore topics that are likely to be most impactful and relevant for financial markets and the global economy.

Welcome everyone and thank you for joining us for another edition of our podcast. In today's episode, which we are recording on the 19th of May, we will focus our attention a little bit more on emerging markets. The global economy has faced a series of shocks over the last few years, but many of the larger emerging markets have taken some quite important steps to improve resilience.

Are these steps enough for emerging markets to be able to weather the ongoing oil shock? Or are there some now that look a little bit more vulnerable as this conflict continues? Eric, there is heightened economic uncertainty and also the risks of stagflation are rising.

Yet EM credit spreads are at pre-war lows and EM equity markets still seem relatively unaffected. How would you explain this lack of reaction from financial markets? Look, this is the fascinating aspect of this crisis in the sense that we know that we've had a commodity shock.

We know that we are experiencing varying degrees of economic shock. In some respects, it's growth focused. In other respects, it's inflation focused.

And we know that the policy challenges, both at the fiscal level and the monetary level, are significant. And yet, as you correctly point out, the various measures of risk that one might look at, especially for emerging markets, whether it's credit spreads or equity markets, seem to be suggesting a relatively benign landscape. And I think that disconnect is causing quite a bit of frustration, not only for clients, but for policymakers as well.

On the equity side, there's a very clear divergence between what we have often called the haves and the have-nots. And in this particular scenario, I think the haves are those who are fully immersed in the technology and the AI evolution. And then there are the have-nots who are not participating and seeing that in their economic outlook.

So EM equities, for example, MSCI EM's market cap, 60% of it is driven by China, Taiwan, Korea, effectively North Asia. And the tech weight in those equity markets is significant. And I think that is certainly driving relative EM equity performance.

And by the way, you're seeing that in markets like the US, right? We've had an extraordinary recovery in US equity markets since early April, and that's been almost completely from tech and AI. On the credit spread side, again, we are seeing this divergence between the haves and the have-nots.

With EM credit indices, I think there's a little bit of a survivorship bias that is driving the indices, which maybe flatters the level of bond spread a little bit. But without getting too technical, I guess the point I would make is that a number of economies still have quite a bit of policy flexibility, the ability to either maneuver monetary policy and or fiscal in a way that helps to mitigate the impact of this crisis. Whereas there are a number of economies that really don't have much of that flexibility, either because of currency depreciation, surge in bond yields, or other constraints.

And I think we're starting to see macro play out under the surface. That divergence under the surface is what macro is all about. And I think we're seeing a lot more evidence of that today.

Thanks, Eric. Could you talk a little bit more about this framework? And also based on this framework, which economies do you think are particularly resilient and which look a little bit more vulnerable?

So I guess in this much more difficult world that we're operating in today, largely because of the crisis in the Middle East, but also some of these really tectonic shifts that we're seeing, whether it's AI, whether it's geopolitical fragmentation, historically, we've talked about the haves and the have nots in terms of growth, in terms of income potential, economic resilience or vulnerability, which you've written about extensively over the years. I think today it's become even deeper than that. I think about this idea of policy flexibility a lot lately, because we're seeing this increase in global bond yields everywhere.

It's not just an EM question, it's EM and DM. And unfortunately, we're now starting to see bear steepening of yield curves. In other words, interest rates going higher led by the long end, not by the short end.

And I think that raises some further questions. But we're seeing divergence in terms of currency performance. Take a region like Asia, right?

We've seen some currencies like RMB and Singapore dollar behave very, very well. And we're seeing other currencies make new, not only year to date lows against the dollar, but in some cases, record lows against the dollar. And I think that reflects a couple of things.

It reflects the vulnerability to the commodity shock. It reflects the, in some cases, the inability to stem the tide of that commodity shock. As we've talked about in previous editions of Macro Freestyle, there's this conundrum for central banks, which is that you're getting the inflation problem up front, but then the hit to growth is going to come with a lag.

And I think for some of these economies, that vulnerability is becoming quite pronounced. The final point I would make is that this crisis and the commodity shock that has come along with it is raising the prospect of resource nationalism again. I think many economies are learning the hard way that being structurally short of natural resources, there's a very high price tag associated with that.

So the divergence between South Asia and even parts of ASEAN with North Asia, I think is one example of that. LATAM continues to be a relative outperformer. Some of that is geographic distance, but some of that is other more regional or local economic factors.

And then you're seeing this play out even within the Middle East. We're seeing the different structures of the economies result in very different economic responses, whether it's Qatar's growth contraction or the relative outperformance of Saudi Arabia from an economic point of view. So again, I think we're seeing this divergence under the surface that is going to continue to play out.

I don't expect a mean reversion of this trend anytime soon. I've talked a couple of times, Madhu, about policy flexibility. I wondered if you could talk a little bit about what you're seeing in terms of the different policy responses in EM, what that might mean for supporting domestic growth and what that means for the stress that is showing across regions.

This is an oil shock, which is now beginning to start to have an impact on growth as well. We have seen the inflation impact come through much quicker across a broad range of countries. And that's why we are seeing a fairly broad mix of policies being deployed.

For example, industrial subsidies are being extended by economies broadly across all regions, even countries that are less impacted. To some extent, household subsidies are also being given. But this is more limited because many countries face fiscal constraints, which make it harder to provide wholesale household subsidies.

For some of the economies which are more resilient, like LATAM, like CEE, like Sub-Saharan Africa, you are seeing fewer measures so far. The focus in these economies will be on how central banks respond to rising inflation. And so rate cut expectations might be taken out.

We might also see over time some rate hike expectations being baked in. But overall, on the administrative side, fewer policy measures are being used. For most developed markets, it's been largely a reliance on supply management measures.

So most of these big economies are members of the IEA. They're looking to release strategic oil reserves and try and help avert the physical disruption to supply. Because it's very important to remember that it's not just an oil price shock.

It's an actual disruption to the supply of oil. But I think where it's most obvious in terms of a broader mix of policy tools being used is in Asia, especially in South Asia and parts of ASEAN, where there's a lot of focus on demand management measures. So things like shorter work weeks, extended holidays, trying to divert resources or prioritise resources towards priority sectors or to households, working from home arrangements.

So lots of these demand management measures are being taken in conjunction with things like tax cuts or subsidies. A lot of it obviously depends on how much fiscal space the country has. And maybe some of this will have to be reversed.

But as of now, the expectation is that maybe countries can just wait out and look for a resolution of the conflict and use a combination of these measures to deal with a potential impact on growth. Of course, the inflation shock will still be there, but the impact on growth maybe can be lessened through a mix of these kind of measures. I wondered, Madhur, if you could share your update on where we are with tariffs, what we think the forward outlook is, what that could mean for economic momentum into and out of Asia and how you think the risks are lined up.

I think it's quite interesting to maybe take a look at how trade has evolved over the last year and a little bit more, given the imposition of those IPA tariffs and all the other tariffs that have been placed on top of that. And what we've seen is very clearly that there has been a slowdown in trade between the US and China, but China continues to gain market share because it has been able to expand its exports to the rest of the world. It's not really directed at any one particular region, whether you're looking at Europe, Asia, Latin America, Sub-Saharan Africa, everywhere, China's exports have continued to rise, which again speaks to your point of there being quite competitive and cost effective.

There is, I think, still some element of transshipments because you can see that China is exporting a lot more to some Asian economies and those are exporting a lot more to the US. But what's really interesting in terms of the change in trend is this focus on AI-related exports that's really been driving the growth story for many Asian economies, China, of course, but also for Taiwan, Korea, even Japan. And you can see that in the import data from the US as well, where imports from these economies have really shot up again, leading to AI being a very important driver of flows.

But overall, I would say that there is a move towards diversification. There is the desire to build new trade corridors. There is still, of course, transshipments.

The US is still the largest buyer in the world. China is still the largest seller of the world. And so we are going to see more evolution of these trade flows over the next few months till we get some more clarity on what's happening.

And there has been a lot of front-loading of trade. And that seems to continue because I think people are still expecting more uncertainty in July or ahead of the midterm elections. People really don't know whether Trump then starts to double down again on trade and tariffs.

So I think there's still some front-loading going on and we just have to track what happens to these trade flows over time. Thank you, Medha. You and I have touched on AI.

It's obviously been a huge driver of optimism and export momentum in certain economies. There's no disputing that. You've just put out a note recently talking about some of the concerns around the AI outlook landscape.

Could you talk about that in greater detail? Yes, absolutely. I think the AI boom is really keeping markets quite bullish.

But there are a few challenges that continue to track. They're both short-term challenges as well as more medium-term challenges. In the short term, I think the biggest would be the availability of industrial inputs for the production of semiconductor chips.

So we're talking about things like helium and sulfuric acid. A lot of the supply comes from the Middle East. And with the Straits of Hormuz being blocked, that supply has been disrupted.

Now, most of the big chip makers have categorically stated that they have enough diversification of suppliers, plus they have enough stocks for a few months. But the longer this conflict persists, people will start to ask questions on how will the chip makers continue to produce those chips in the quantities that are required unless you have access to those critical inputs. I think on a more medium-term basis, questions are going to be raised on whether we might see a slowdown in investment spending in terms of data centers or trying to build out AI capability.

And so far, the hyperscalers are doubling down in terms of investment. If you've seen their Q1 results, then clearly they've tried to say that they're going to expand investments, being quite optimistic on this. But given the potential growth slowdown, if there isn't demand, then can you continue to expand supply?

So that will be more of a theme, I think, as we go ahead. But the biggest theme, in my view, and the most critical one for the global economy has been that we have been very hopeful that the AI-led technology boom will be what triggers a productivity growth boost that will help alleviate all these concerns about debt and fiscal sustainability. But historically, when you have an energy shock, firms and consumers tend to slow down the adoption of technology and AI.

Because their operating costs have gone up, they have to prioritize other things. And so you have historically seen energy shocks being related to a slowdown in investments by firms, a slowdown in productivity growth. And what's most concerning would be that this slowdown in productivity growth tends to be higher when it's a supply-driven energy shock, which is what we are going through currently.

And also it tends to be higher when you have greater economic uncertainty. So these are things to monitor. But I think for the more medium term, the productivity story will be key because a lot of our expectations in terms of fiscal space and fiscal sustainability will be driven by how productive economies are going to be over time.

Now, Eric, I've outlined some of the key areas of concern for AI, but I haven't talked a lot about China. And you've mentioned China and the tech optimism there. Do you see potential offsets to a potentially weaker AI story?

Or could China use this as an opportunity to close the gap with the US as an AI leader? I guess there's a couple of potential angles to consider. One of the potential hurdles to the AI agenda in the US is, and especially for computing power and data centers, et cetera, is simply access to power.

And one of the things that has been very clear to me and was made clear again on my recent visit in China is the importance of their investment in solar and alternative energy, which really has helped them considerably. And a number of the people I met with asked if perhaps this issue of power sourcing and power cost during an energy crisis might allow China to, as you said, narrow the gap with the US. I heard a number of clients when I was traveling ask if one of the sort of gaps between the US and China on this was that the US was still maintaining a very strong lead in terms of early stage innovation, but that China was catching up and perhaps might even quickly exceed what the US was doing in terms of adoption.

And whether it's things like the combination of AI and robotics in the medical space, for example, these were examples where I think China was demonstrating a real competitive edge. And so I think there are a handful of interrelated themes here. One is being able to source power in a cost effective manner.

The other is where you are on the innovation or adoption spectrum. We can think back to the emergence of social media and payment systems on social media platforms. The US was very early in terms of some of these social media platforms, and then China adapted and adopted very, very aggressively.

And all of a sudden we have things like WeChat with incredible payment systems attached to them. So I think the AI forward outlook is going to have some echoes of what we saw in the social media race. And so I wouldn't say it's changed my view on whether to be optimistic or pessimistic or skeptical about AI.

I'm still very optimistic about its use cases and how it will help businesses. I think the US and China may have different approaches in terms of that AI applicability. And Eric, maybe finally coming back to financial markets, bond markets have started to react to the energy shock.

You're seeing a bear steepening of yield curves, as you mentioned. How do you see this playing out for emerging market economies, their external funding prospects and generally EM bond markets? So I guess the short answer is I'm concerned, although for those who read my notes and listen to our podcast, that's not a new concern for me.

I suppose what the oil shock and commodity shock has done for my views is it has accelerated the timeframe for which I think we need to be worried about some of these fiscal issues. Because the way I see it is what this crisis has done, it has forced governments to respond in some cases aggressively with fiscal intervention. Many of them don't have the fiscal space and maybe their bond yields are not going up aggressively, but their currencies are weakening or it's the other way around.

And I think we're learning very, very quickly who has policy flexibility and who does not. And by the way, this is not just an EM challenge. We're seeing the same in DM.

We're seeing the same in Japan. We're seeing the same in the UK. Some of the more liquid or developed economies of North Asia, like Korea, have seen a surge in long-term bond yields.

And so the way I think about this and what really concerns me is that I feel like we're getting closer to a point in time where maybe there's a negative feedback loop. The fiscal is feeling more pressure to support domestic economies, to protect their consumers, to protect their small businesses. That puts pressure on bond yields.

But to service those bond yields, governments need revenue. And in a world of declining growth and higher inflation, that revenue is going to become harder and harder to come by. And so the risk, in my opinion, again, for both developed and emerging economies is that we are moving into this negative feedback loop where debt sustainability really becomes front and center.

And we've talked about this for years, but it feels like this crisis could have brought us closer to the point where actually it's no longer a risk way off in the future. It's a risk in the here and now. Now, the only thing that has not happened as of yet, and you asked about this at the start of our discussion, is we haven't seen this reflected in credit spreads.

We haven't seen this reflected in sovereign spreads yet. And my concern is that the recent bear steepening of sovereign curves is a precursor to spread widening. And there's going to be an increase in debt supply in the second half of the year.

And with that, there's going to be an increase in corporate debt supply. And I worry a little bit about the collision of those two trends. So we'll see how that plays out.

It's not a terribly uplifting note, but I think we need to be aware that financing costs for borrowers, sovereign and corporate, are going higher. And I think we need to get our arms around that pretty quickly. That's all we have time for.

Thank you, Eric. And thank you all for joining us today. We hope to speak to you again next month.