We enter autumn with many political and policy issues overhanging financial markets. The main underlying global story is continued strong growth in the US and the prospect of further policy tightening by the US Fed. Outside of the US, the growth picture varies, as does the immediate outlook for monetary policy.
Over recent weeks, however, we have seen enough evidence of how many big global issues are yet to be resolved. The crisis that has impacted a handful of emerging market countries led Argentina to finally hike rates aggressively; taking action the market thought was necessary some time ago. There has also been a focus on trade issues, including NAFTA talks between Canada and the US, conflicting comments on UK-EU trade issues and worries about Sino-US trade.
President Trump last week turned up the rhetoric against China on trade, at the same time Chinese officials were in Washington. Stock markets, naturally, are wary of the economic, financial and geopolitical fallout from the tit-for-tat approach to trade between the US and China.
On the economic side, the worry is that it will dampen growth in both economies, curbing exports and impacting business sentiment. There are also concerns this friction may spill over into the wider geopolitical ties between the two with a negative impact on still unresolved issues such as North Korea and navigation rights in the South and East China Sea.
Since the beginning of the year, a combination of factors have clouded the outlook for emerging markets. The initial cause of tension was rising US interest rates and, for much of this year, a stronger dollar. In the past this has caused problems for over-indebted emerging economies that have borrowed in dollars. The fear was that this would be a problem now. This worry was then compounded by the fear that a trade war would dampen global growth and hit exports from emerging economies.
Initially the problem was felt in specific emerging economies, particularly Argentina and Turkey. But markets often like acronyms and attention was focused on the so-called “BRATS” of Brazil, Russia, Argentina, Turkey and South Africa. All of these had domestic challenges that left their currencies and markets vulnerable. Indeed this week data showed South Africa falling into recession. Now, market contagion is spreading, with Indonesia’s currency the latest to weaken significantly, and there are wider concerns about emerging markets.
There is a tendency for financial markets to overshoot. And this can be very noticeable in emerging markets that lack depth and liquidity. Moreover, a characteristic of many bull markets is crowded trades, where institutions take the same positions and then rush for the exit door at the same time, compounding the sell-off.
It is important to differentiate across emerging economies. Not only are geographic regions like Asia, Africa and Latin America, among others, very different in economic and financial terms, but there are often large differences between countries in the same region. Also, there can be distinctions between how markets behave in the short term and how economies perform. There is little doubt emerging regions will account for more of future global growth, particularly the further ahead one projects.
Many advanced economies will perform well too, and we have often talked of the attractions of the Indo Pacific, from India through to China and east Asia and to the USA. Despite longer term attractions, the sell-off in emerging assets can become self-feeding, but creating opportunities in the process. A key factor in how things will evolve will be the performance of China, the largest emerging economy, which we focus on here.
While this appears to give the impression that policy is on a steady path, the economic messages from July’s Politburo meeting pointed to worries about a slowing economy versus the message from the Politburo meeting in April. For instance, the first key message in April was “the economy was stable while improving”; in July the words were “stable while changing”.
Likewise, the second key message in April was “the supply-side structural reform needs to make further headway, as well as winning the “three tough battles”.” By July this was “Bolster areas of weakness is regarded as the key task of deepening the structural reform of the supply side, increasing the strength of the infrastructure sector to complement the areas of weakness”.
The third key message from April to “safeguard the floodgate of money supply” had by July evolved into “safeguard the floodgate of money supply and keep the liquidity reasonable and sufficient”. Additionally, in July the Politburo had a fourth key message, “We are determined to solve the problem of the real estate market.” That problem being one familiar elsewhere: it is expensive and too much activity is speculative. Thus, while the focus is still steady growth, low inflation and improving the supply side of the economy, policy was being tweaked.
One concern for global financial markets in recent months has been that the trade issue could slow the pace of growth. By easing policy China provides another prop to its economy to allow it to withstand any of the negative impacts from the trade dispute. In doing this, the authorities are likely to want to send a clear message to firms and people not to lose economic confidence.
Also, indirectly, one would imagine that the more China looks able to withstand any negative fallout from trade, the stronger is its hand in any trade negotiation. But what does this mean for the domestic debt picture and for the currency? These are two areas that markets will watch.
The build-up of Chinese debt has already triggered fears. The scale of this debt is a worry. Debt to GDP has risen from around 141% in 2008 to double that by the beginning of this year. If debt is rising, but GDP growth is not matching this, then the payment capacity is deteriorating. Also a worry is the distribution of debt, with the Bank for International Settlements citing that while household income has risen threefold, household debt has increased ninefold in a decade.
Although household debt has risen sharply, it is the level of corporate debt that attracts focus, as it is so high. It used to be feared that this was coming from the ‘shadow banking’ industry, but the vast bulk of corporate debt is now proven to have been from the banking sector. Corporate defaults were low in 2014 and 2015 but shot up in 2016 before easing slightly last year. There have been defaults this year, although corporate profits are high.
So, the picture is nuanced. Thankfully, government debt is relatively low, at 50%. This allows the market to assume that if there is a problem the government will step in, and somehow, assume the debt problem.
The question remains as to whether China may be able to buck the trend seen elsewhere, where a rapid build-up of credit or debt has usually been a precursor to problems. China, at an official level seems to recognise the challenges. Hence the focus until recently on deleveraging (reducing debt).
The IMF’s research shows that in 43 credit booms seen in other countries, like the boom China has experienced in the last five years, in all but five there was either a sharp slowdown in growth or a financial crisis. This feeds into market concerns now.
The currency option
The other policy option is to let the Chinese currency weaken. While the financial problems in Argentina and Turkey have not led to widespread contagion across emerging economies, within Asia there is a nervous focus on what happens to the CNY (Chinese yuan).
It is still unclear how much of a problem a stronger dollar has caused across Asia – there may be some corporates who have borrowed in dollars, albeit not on the scale as seen in Turkey, and who would thus be in trouble – while there are also some countries who will face higher import bills and inflationary pressures if the dollar remains firm and commodity prices rise.
But, if in addition, the CNY weakened sharply then this would add to competitive pressure for many exporters across Asia. Thus, a weaker CNY is seen as something that Asian economies and markets would like to avoid.
Prospects for longer-term growth
For longer-term investors in China the picture has not changed. There is much to be positive about. But in the near term, there is naturally increased tension, largely because how things will play out will be heavily influenced by political and policy decisions both in the US as well as China. Presidents Trump and Xi are scheduled to have two one-to-one meetings this autumn. These may resolve issues.
I am mindful of the comment relayed to me many years ago by a senior policy maker in China, when we discussed whether there may be a soft or hard landing for the economy. His comment was that there would be neither, as they would always try and make repairs in mid-flight. At that time the focus was on strong growth at all costs. Since then, the focus has been on the quality of growth. Hence the comments of Liu He, mentioned above, at the beginning of this year, are very relevant.
The authorities are taking action to shore up growth now, since the summer, but the previous deleveraging policy will need to resume. The trend for the Chinese economy is up but the future pace of growth will be slower than in the past and will be more volatile, with setbacks likely along the way. In recent months the aim of policy makers appears to have been to provide some more breathing space, but the overall aim is still to deleverage the economy and have a better balance of growth. The tough battles, outlined by the authorities at the start of this year, are still being fought.
These developments are naturally important considerations in our investment strategy, helping to inform our longer-term strategic thinking, as well as raising issues to consider with respect to cyclical positions, ensuring we are aware of near-term risks as well as opportunities.
Financial markets watch China not only for the direct impact of performance of its own market, but also for any contagion that may spread across developing markets – which currently look more vulnerable given events in Turkey and Argentina and worries about South Africa and Indonesia.
This uncertainty also adds to a focus on currency markets, with the potential for increased volatility, and the attraction of safe havens like the yen. In addition to taking into account these global drivers, it is always necessary to look at valuations from a domestic perspective to see where there is safety as well as value.
Please remember that when investing your capital is at risk.