There is much optimism towards the outlook for economic recovery in emerging markets (EM) this year.

Despite concern over the roll-out of vaccines, we still expect EM GDP to expand by about 7% in 2021, following a contraction of 1.6% in 2020.

Significant US fiscal stimulus is on its way this year. And since we updated our forecasts, a $1.9 trillion American Rescue Plan has been approved by Congress. Against a backdrop of successful vaccine distribution, we recently nudged up our forecast for 2022 GDP growth to close to 5%. That leaves us above the consensus forecast for growth of 6.5% and 4.7% this year and next.

The drivers of EM growth are likely to rotate as we move through this year.

In the near term, China and other export-orientated economies in Asia should continue to fare relatively well on the back of strong demand for manufactured goods. However, this cyclical recovery is likely to fade during the course of this year.

We anticipate that the growth baton will pass to other EM as inventories are replenished and the re-opening of the global economy re-orientates demand away from manufacturing goods and back towards services. If we are right, then the recent outperformance of Asian markets may begin to reverse.

A strong start to 2021 for emerging Asian economies

After performing relatively well compared to the rest of EM last year, Asia has been quick out of the blocks in 2021. The data published so far in China points to an extremely strong first quarter. The lagged effects of stimulus, coupled with the effect of starting from a low base, look set to lift Chinese GDP growth towards 20% year-on-year (y/y) in Q1.

Meanwhile, shipments from the region’s export-orientated economies have also been strong. Indeed, when measured in US dollars, the combined exports of China, South Korea and Taiwan rose by about 50% y/y in February. Those figures have also been flattered to some degree by the low base effect stemming from the outbreak of Covid in the region last year, and the usual distortions around the Lunar New Year holiday.

Nonetheless, trade has undoubtedly been strong. Indeed, when stripping out some of the volatility by comparing exports to the same period in 2019, shipments are still up by more than 10%. And all of this has supported the impressive performance of Asian equities.

Three reasons EM growth leadership is set to change

However, there are at least three reasons to think that the growth baton will pass from Asia to other parts of EM as the year progresses.

1. Leading indicators of China’s economic cycle appear to have peaked.

The authorities have so far been treading carefully in withdrawing monetary and fiscal stimulus as the economy has recovered. And despite announcing a confusingly low growth target for 2021, the government has signalled that fiscal policy will not be tightened aggressively this year. However, gradual policy tightening, coupled with tighter regulations for the property sector, is still likely to take some steam out of activity.  We expect GDP growth to slow from about 9% this year to around 5.7% in 2022.

2. The manufacturing cycle in Asia appears to have largely run its course.

In particular, the ratio of the new orders to inventories sub-indices of the Caixin manufacturing PMI has fallen sharply since reaching a peak in the autumn. When the ratio is high, inventories of goods are low relative to incoming orders, leading to an increase in manufacturing output. When the ratio is low, new orders can be met more easily from existing inventories without the need to increase output.

The decline is due to firms having caught up with strong demand for goods during the pandemic and as export orders have softened. This has taken away a key prop to strong industrial production growth. China’s central position in global supply chains means that its manufacturing sector tends to lead that of elsewhere in Asia (and indeed the world), suggesting that the inventory cycle in the region will soon turn.

There should be some additional demand as stimulus packages in the West are delivered, particularly in the US. And there are some idiosyncratic stories that will support activity such as in the semi-conductors sector. But on the whole, it seems that export-led manufacturing will lose impetus during the course of the year as the re-opening of the global economy sees demand shift away from goods and back towards services.

3. Growth to accelerate

Third, and related to this, just as industrial activity in Asia comes off the boil, we expect growth in other parts of EM to belatedly accelerate as the worst effects of the Covid crisis fade and vaccinations are rolled out.

The fact that many Asian countries dealt relatively well with Covid and rely more on manufacturing means that they will benefit less than other EM, with larger services sectors from the roll-out of vaccines and “normalisation” of activity.

There are of course nuances in the story, with some markets such as Chile set to vaccinate their way to herd immunity this year, while others such as South Africa and Mexico may reach it by accident after managing the crisis poorly and suffering high infection rates.

Meanwhile, others such as Brazil may be about to suffer another wave of infections that could weigh on the recovery. The recent uptick of infections in India is also a worrying development in this regard.

But on the whole this ought to see other regions take over from Asia as the driver of EM growth.

What does this mean for investors?

This suggests that investors ought to rotate within EM over the course of this year.

For example, Asian equities have outperformed those in Latin America in line with the differential in GDP growth between the two regions.

Our macroeconomic projections suggest that this could reverse to some degree during the course of this year.