America sneezes – Emerging Markets catch pneumonia
The portfolio performed very well in May, taking the year to date net gain to 15.0%, vs. 3.5% for the index. There were two causes for the good numbers: stock selection – i.e. ignoring index weightings - and the avoidance of countries with deteriorating balance of payments and budget deficits, and with high government debt to GDP ratios, such as Hungary, Poland, India, Turkey and South Africa. In the last two, market weakness coincided with currency falls of 17% and 6% respectively for May alone. Investors in Emerging Market indices have had two brutal reminders; that although these countries now constitute a significant part of world GDP, their capital markets continue to react like warrants to policy changes in the developed countries, especially America; and that relatively strong economic growth does not in itself lead to better index performance or growth at the earnings per share level.
The Federal Reserve Bank created greater turmoil than it could have possibly anticipated when announcing - with many caveats – a reduction in its bond purchase programme which might commence later this year. Equity markets globally fell on the news; bond markets swooned. The greatest impact was in those EM countries lacking institutional depth and where excessively high valuations were driven by huge foreign investment into their often thin markets. Their debt markets suffered especially dramatic falls. After a 32-year bull market for bonds in the developed world, investors have been warned that an inflexion point has been reached. This bond bull market burst its bounds relatively recently, causing extreme inflows into EM countries. For equity markets however, the picture is different because of increasing risks of deflation. These make any significant reduction in central bank bond purchasing programmes in America or other developed countries improbable. With their high debt-to-GDP ratios, servicing costs of the bloated government debt in these countries would soar in real terms. More importantly, once the political masters of their central banks realise what is happening, they will undoubtedly force a reversal of policy because deflation guarantees political defenestration.
The world’s second largest economy, China, has enormous but different problems. The shadow lending market, estimated by the Financial Times at Rmb 28 trillion, or 50% of GDP, is in trouble; June’s giant leap in interbank rates was but one of many warning signs. The liquidity squeeze will ricochet into mainstream banks, which have underwritten much of the shadow banking sector. Most indicators point to slower growth, accelerating bad debts and weaker company profits. The Purchasing Managers’ Index has been trending lower for three years, partly due to chronic overinvestment in infrastructure projects and property, plus a lack of capital discipline by industry. Any progress to a more balanced consumption-based economy has stalled. China’s production remains impressive, churning out ever more coal, ships and steel. Yet so great is the overcapacity into flat demand that profitability has tumbled.
Like witch doctors studying chicken entrails for messages, so data-obsessed economists have made tiny tweaks to their GDP numbers. Given that China produces detailed economic statistics (which are almost never revised) ahead of any other major country, sometimes before a reporting period has ended, much economic ‘analysis’ is voodoo. Longer term trends however give clearer signals. From manufacturing exports to commodity prices and import volumes, and other more accurate numbers such as electricity consumption, indications are all of a significant slowdown. Hence those countries which have ridden on the coat tails of China’s once rapacious demand, such as Australia, Brazil or South Africa, must suffer, as will those Asian countries linked into the ‘greater China manufacturing chain’. This change comes at a bad time, given European demand will stay flat and growth in US imports is lagging that country’s modest recovery. Meanwhile, Japan’s dramatic policy changes, such as weakening the yen/dollar rate by 20% since November 2012, has both slowed its volume of imports from EM countries and squeezed their margins, even as Japan has revived as a cheaper global competitor in exports.
The silver lining
There is an easy case for further crises in EM capital markets and more problems in their bond markets as a consequence of the June panic. India is one example. However, record levels of bond sales internationally by many EM governments and companies - which were hysterically snapped up by eager foreigners at ridiculously low interest rates, whilst also ignoring balance sheet risks - do have plusses. Many of these EM companies and governments are substantially better funded at cheaper rates than five years ago. The sharp falls in their equity markets have resulted in cheaper valuations, particularly domestic consumption stocks which represent the real emerging market growth and value story. In countries more popular with investors, the overpricing of their currencies is ending; renewed dollar strength is likely, so will improve their competitiveness. Most important, the alarm over US tapering is exaggerated and ignores that Japan is doing the opposite, by printing money as never before, a policy the EU is likely to be forced to follow before the year end. Moreover, America will still have in excess of a trillion ‘support dollars’ sloshing around the system. Previously this would have found a home in ‘risk-free’ bonds, but that bull market’s back has been broken. Under-owned equities are natural homes for future flows looking for the higher yields more prevalent in EM countries.
© Bedlam Asset Management
