Emerging markets perform resiliently in the year-to-date despite growing cyclical headwinds

Manufacturers in emerging markets have performed strongly over the past 12 months, withstanding the economic drag from weakening global trade, rising borrowing costs, geopolitical tensions and high inflation. According to S&P Global Manufacturing PMI data, output growth across emerging economies excluding mainland China recorded its strongest quarterly average for 12 years in the second quarter of 2023. This compares with the manufacturing sector in advanced economies, which saw production volumes fall at the fastest pace in three years in June. Subsequently, the outperformance of emerging markets excluding mainland China over developed markets stands at its widest since the Global Financial Crisis.

Historically, such large divergences in manufacturing performance between developing and advanced economies are not sustained as weakening economic conditions in the major global forces are a drag on global trade, restricting the export-led growth many developing economies rely on.

However, the strong positive correlation (88%) between trade and emerging market growth has broken down since the first half of last year, with factory production across emerging markets even strengthening as export volumes fell. Global trade performance has been undermined by a number of factors since 2022, such as households rotating their consumption away from goods to services, which are less traded across borders. The global inventory glut has also been a headwind for trade as companies work through material stockpiles instead of making new purchases. This is highlighted through the Global Manufacturing Quantity of Purchases PMI, which was in sub-50 contraction territory for an eleventh successive month in June. Fragile global demand conditions mean businesses are likely to limit how much they put into their inventories, which will put a further dampener on trade. This typically would suggest that emerging market manufacturing is at risk of deteriorating.

We are not yet seeing any signs of underlying weakness in the PMI data, though. In fact, total demand for goods manufactured in emerging economies has grown solidly in the year-to-date, outpacing new export order growth, which indicates supportive demand conditions domestically. Notably, the order-to-inventory ratio - which tracks changes in demand relative to stocks of finished goods and serves as a leading indicator of factory production - has risen sharply in 2023 and is well above 1.0 for emerging markets excluding mainland China. Readings above 1.0 indicate that new orders are rising faster than inventories and suggests production levels need to rise further to meet demand. This also suggests the breakdown in the correlation between emerging market output growth and global trade has further to run. This contrasts with the developed market trend, which implies manufacturing production will continue falling in the near-term, widening the divergence even further.

One reason why domestic demand conditions are holding up better in emerging markets compared to advanced countries might be the difference in inflation. While households and businesses in emerging market economies are more accustomed to higher inflation than those in developed markets, which may explain some of the resilience, inflationary pressures were much more benign in developing markets and peaked lower than in advanced economies. This meant that the passthrough of rising costs to selling prices, and thus the damage to purchasing power, was lower in emerging markets, leading to weaker downward pressures on demand.

Central bank policy will also be playing a role. Monetary policy makers in emerging markets were far more pro-active in raising interest rates early to combat rising inflation than their peers in the advanced economies, who have struggled to convince households, businesses and financial markets that they have got control over prices. This is damaging to confidence, potentially leading to further retrenchment if consumers and firms expect inflation to remain elevated.

In summary, resilient output growth in emerging market manufacturing appears unsustainable due to falling global export demand and deteriorating economic conditions across advanced economies. Such divergences do not last, according to historical data. Global trade conditions are unlikely to be supporting for emerging markets, but domestic demand has been robust and emerging market central banks have seen greater success in containing price pressures than in advanced economies. Subsequently, the near-term output for emerging markets is much more robust relative to advanced economies, according to PMI data, and leading indicators such as the order-to-inventory ratio suggest that factory output growth is likely to be sustained in the near-term, contrary to the downward trend implied by a negative outlook for global trade.