THE HISSING EM CREDIT BUBBLE – WILL IT POP?

 “All the perplexities, confusion and distress in America arise, not from defects in their Constitution or Confederation, not from want of honor or virtue, so much as from the downright ignorance of the nature of coin, credit and circulation.”
~ John Adams


Dear Mountaineers,

With Janet Yellen taking over the reins from Ben Bernanke as the new Chair of the Federal Reserve, a number of events and increasing tensions in emerging markets, including Eastern Europe, remind us of the vulnerability of the recovery (or as described by the Economist, the “worldwide wobble”).

At the source of the economic weakness, we are witnessing across emerging markets the traces of a credit cycle gone too far and, slowly but surely, coming to an end. The financial media is full of new acronyms, for example the “Fragile Five” (recently “upgraded” by the Financial Times to the “Fragile Eight”).

Economic growth in emerging economies has indeed been in a downtrend for some time. Nevertheless, until recently, due to the still relatively impressive growth, certainly in comparison to western standards, much hope rested in EM growth. Increasingly, these hopes are being replaced with concerns.

So the question is: Are emerging markets going into a crisis mode that could inflict the rest of the global economy?

Chart: HSBC Emerging Market Index (EMI)
Composite Output Index, seasonally adjusted

Source: Markit / HSBC

Recent capital outflows and currency fluctuations have been hurting the health of several EM economies, including some large ones in Asia. As investors, we are facing a mixed picture that isn’t easy to decipher. Our expectations at BFI are that, at least in the short-term, stock markets have more potential to continue their rise. However, EM deflationary trends will persist. And the potential for an upset is considerable.

Yet, we don’t see an imminent repeat of the Asian crises as we saw in 80’s and the 90’s. First of all, you need to differentiate on a case-by-case basis. While the balance of payment imbalances in several countries is substantial, especially in China, most of the Asian economies are structured, in terms of their debt, much more solidly than they were back then. For one, the level of foreign debt exposure is not as high as it used to be.

Furthermore, developed market fundamentals currently do incorporate at least some hope for improvement. And, the currency devaluation of course is not all bad. It has supported exports. So, in some countries, including India, balance of payments deficits are being reduced.

Tapering pressure on EM currencies

The currencies of the largest emerging economies with the highest balance of payments deficits – Brazil, Indonesia, Turkey and South Africa – have devalued about 20% since the beginning of 2013.

This year started with EM currencies under pressure again. In most cases, this has been a result of capital outflows as America continues tinkering with tapering, or stepping on the breaks of its quantitative easing money machine. Since the beginning of the year, the Argentine peso has dropped by 18% against the Greenback (although not primarily for the reason of capital outflows). The Russian ruble and the South African rand depreciated by approximately 7%, while the Turkish Lira lost about 5%.

Meanwhile, the Renminbi as of last week came under pressure, as did several other Asian currencies. All this occurred despite the respective central banks raising interest rates.

It is no surprise that emerging markets are currently not en vogue with professional investors. EM financial markets are lagging behind those of more developed markets.

A boom built on excessive credit

The current problems are the delayed consequence of the massive capital flows from developed economies over the past years. In search of attractive yields, and as a result of the prior success of emerging economies, this influx of capital into the respective emerging economies was met by governments’ reluctance to allow their currencies to appreciate. The resultant “cheap money” policies – to some degree, a carbon-copy of the monetary policies implemented America’s Federal Reserve, and then of the ECB – led to an explosion of credit growth and a surge in domestic consumption. The result was growing current-account deficits.

Now, the tide has turned. The stabilization in the Euro zone, the improved growth in America and the tapering-talk that has come with it have reversed capital flows. As a result, those emerging economies with the greatest current account imbalances will face a prolonged adjustment period. Internal growth will drop considerably and a tricky mix of price wars, currency devaluations and inflationary monetary policies can be expected.

What about China?

China is no exception, on the contrary. While the economic performance of China over the past 20 to 30 years is certainly impressive, China has – particularly after the 2008 episode – experienced one of the most dramatic credit booms of modern history. Over the past 5 years, China’s total outstanding credit has more than doubled. It has grown more than the equivalent size of the total US commercial banking sector – worth USD 14 Trillion! That is the equivalent of 150% of China’s current GDP. Since 2000, as a result of its ultra-easy monetary policy, the Chinese central bank has showed the biggest balance sheet expansion of all central banks.

As stated by Felix Zulauf in his recent Investment Comments, China faces the mother of all bubbles: “Credit growth in the years leading to the bursting of previous bubbles has been 40% to 50%, as was the case in the US from 2002 to 2007, in South Korea in the mid-90s and in Japan in the late 80’s. China’s credit growth has been by far higher than all of those. Now, we see all the earmarks one usually gets before the bubble bursts”.

After 2008, an extreme deflationary scenario and depression – created by a “disorderly” liquidation of excessive debt – was barely avoided. At the time, the spotlight was mainly on western economies. Today, the “deleveraging abyss” has moved to the east, and the ability of the Chinese government to manage structural reforms and to deflate the credit bubble smoothly will be crucial. What investors should consider is that the issues Russia, South Africa and Turkey are going through are mere sideshows in comparison to China. The global implications of an unruly credit crisis in China are generally being underestimated. 

Demographics not to be disregarded

In a recent publication titled “Equity Gilt Study”, the economists at Barclays point out the oft- neglected importance of demographics and how, based on the makeup of their respective demographics, some economies are more exposed to deflation than others.

In the following chart, an astounding correlation between the trend of deflation and Japan’s aging population is depicted. Approximately around the time when Nippon’s real estate bubble burst, the country’s demographics started deteriorating.

The country’s working age population has been shrinking about half a percent per annum since the mid-nineties. In aggregate, it has shrunk by about 10% during that period. Such a drastic reduction dampens the economic vigor of a country and the income perspectives of the people. It becomes harder and harder to increase salaries and prices. They stagnate and then drop lower and lower. Demographic shrinkage thus can serve as a catalyst toward deflation.

Japan’s painful experience reminds us of the fact that several large economies confronted with deflationary pressures are also afflicted by a shrinking working age population. This concerns Europe – particularly Spain, Portugal, Italy, and Greece – as well as China.

Chart: Japanese working age population vs. core CPI

Source: Haver Analytics, Barclays Research

With an attempt to give you a broad-stroke overview, let’s get back to the question posed in the title of this commentary: Will we get “pop”? Are we headed for the next Emerging Market Crisis? Will we witness a repeat of what we experienced in the 80’s and 90’s?

In the short-term, we don’t expect that to happen. Currently, investor and consumer sentiment in Europe and the US are too positive.

Europe has been the winner in stock markets over the past few quarters, particularly the peripheral markets. Equally, international bond investors looking for yield and concerned about Asia shifted much of their attention and funds to the peripheral Euro zone. Consequently, European yields have “normalized” since the debt crisis in 2012. Fears of a Euro break, at this point, have largely vanished.

Yet, the fundamental debt problems in Europe persist. They are far from solved. Also, the political developments in Europe need to be monitored. The Ukraine situation is not to be disregarded. And, although not of huge importance at an initial glance, the signaling implications of the recent Swiss vote on immigration should also not be underestimated. There is reason for the EU’s aggravation – other Europeans would love to be given the Swiss people’s say and have the chance to vote on immigration. The EU elections coming up in May promise to be very interesting and telling.

Globally, the US economy is performing the best, even though the fundamental indicators reported appear a bit too low as a result of the harsh winter. Irrespective, consumer numbers in America indicate that consumers are more willing to borrow now than they have been in a long time. Employment is improving. Real income is moving up in very small increments. Overall, the US is doing relatively well compared to other parts of the world. This will support the dollar and US stock markets.

As depicted in the following chart, emerging market economies are currently able to benefit from the recovery in more developed markets. Here you will see the close correlation of EM economies with the health of developed economies.

Chart: Emerging markets benefitting from developed markets recovery

Source: OECD, CPB; as of February 5

If the positive forecast for OECD domestic demand for 2014 (as displayed on the right-hand side of the chart above) holds true, that should give emerging markets some much needed support in their exports. 

So, in conclusion, although the imbalances in emerging markets, and especially in China, need to be “managed” and have the potential for stark turbulences, we don’t expect a “pop” in the short-term future. As long as news from America remains positive and as long as Europe’s political tensions are successfully silenced and the debt problems in peripheral Europe remain under control, emerging markets should be able to stay in ‘hissing mode’. However, beware of any bad news or surprises.

Therefore, in the coming months, it will be critical to differentiate thoroughly between different markets and to be increasingly selective. While there is still good upside potential in stock markets, we don’t expect the appreciation in stock markets to be as broad as in 2013. Particularly in the emerging markets sector, we expect to see a number of potentially stark disappointments.

Sincerely,

Frank Suess

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