A world turned upside down

THE headlines will probably be captured by the better news from Europe this morning, with the purchasing managers' index confirmed above the 50 level in the euro zone, and a very strong number (54.6) in the UK. But the more interesting data are to be found in Asia, as Krystal Tan at Capital Economics points out. The PMI fell in five out of the six countries reporting and was below 50 in four (Australia, South Korea, Taiwan and Vietnam). The forward-looking component - new orders - was below 50 in all bar Indonesia.

The momentum of growth is shifting from the developing to the developed world. Clearly, this is largely a cyclical issue although there is a secular trend as well, as our last issue explained. What does this mean for markets? Slower developing world growth means, on balance, less pressure on commodity prices. That will help Western consumers and will also add to the deflationary pressures mentioned in yesterday's post. Indeed, were it not for the stubborn strength of oil, inflation might fall even further. Whether that will last, given the downward trend in oil futures, is open to question.

Roughly speaking, developing and developed world activity are each around half of GDP. But of course, the former grows much faster. So the developed world might have to motor quite fast to make up for a slowdown in emerging markets; the latest estimate of world trade showed a small fall in May. Slow growth, falling inflation; doesn't seem like a market in which investors should be piling out of bonds and into equities.

Still, it all depends on the price, of course. And the same is true of emerging market equities. They are often bought for their growth prospects but there is virtually no relationship between short-term GDP growth and equity returns, as veteran investors in China will know to their cost. The corollary means that a short-term period of sluggish growth should not put investors off. Morgan Stanley calculates that emerging market equities have underperfomed their developed counterparts by 18% over the last six months, one of the worst relative performances in history. As a result, the relative price-to-book ratio of emerging markets is 0.73, the lowest since 2004.

This de-rating is not irrational; the return on equity of emerging market companies was 87% higher than that of developed market companies three years ago. Now it is just 10% higher. To me, this suggests a worry for companies in the developed world. Emerging market companies, faced with slower economies, may try to compete abroad. And that may mean a squeeze on margins in the rich world.

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