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Not yet time

22 Dec 2015 By Edward Chancellor

The bad news from emerging markets has been unrelenting. From corruption scandals in Brazil to violent attacks in Turkey, emerging countries have faced an assortment of troubles. Financial assets linked to emerging economies have been hit hard. The MSCI Emerging Markets Index has fallen by around 16 percent over the past year, while JPMorgan’s Emerging Markets Global Diversified Bond Index is down some 30 percent from its peak. Last November, Goldman Sachs, the loudest emerging-markets bull on Wall Street, shuttered its so-called BRICs fund after assets had shrunk by nearly 90 percent.

The good news is that expected returns across emerging markets have improved. Ben Inker, the co-head of asset allocation at GMO in Boston (and, in full disclosure, my former boss), expects emerging equities to return, in real terms, a tad less than 5 percent annually over the next seven years. By contrast, GMO’s forecast for U.S. stocks over the same period is slightly negative. In the short run, however, performance is likely to be determined by liquidity conditions, both global and domestic. On that front, there are reasons to believe that investments outside the developed world could face another rough year ahead.

Stock markets in places like Brazil and Russia typically do well when money is cheap and the dollar is weak. Since 2011, global liquidity has contracted and the dollar has strengthened, making life tough for emerging markets. This headwind is set to continue. The Federal Reserve’s tightening cycle is only just beginning. Many companies across emerging markets took advantage of ultra-low U.S. rates to borrow abroad in dollars. As a result, there’s around $1 trillion of foreign-currency corporate debt strewn across Asia, according to GMT Research.

It’s difficult to see a sustained recovery of capital flows into emerging markets until the Fed has finished raising rates, and the aftermath of this emerging corporate borrowing binge has been addressed.

The credit cycle across emerging markets also looks set to continue on its downward path. It’s true that credit growth has come down a lot in recent years: outside of China it has declined from a post-Lehman Brothers peak of around 18 percent to an annualized 7.5 percent in the 12 months to October, according to Mike Biggs, a strategist at GAM, a Swiss-based fund management group. This declining pace explains much of the recent weakness in emerging-market economies.

Bears, pointing to the fact that the stock of emerging-market debt has expanded greatly in recent years, suggest that it’s not safe to buy emerging markets until they’ve started to pay some of it down. This analysis is flawed, says Biggs. What’s important for investors is not the amount of debt which a country owes but how the rate of credit growth changes from one year to the next. What Biggs calls the “credit impulse” determines short-term changes in GDP growth and has a huge impact on asset prices.

Think of it this way. If credit is growing by 15 percent of GDP in one year and by 5 percent in the following year, then the stock of credit is increasing. However, the “credit impulse” is negative to the tune of 10 percent of GDP. It sounds counter-intuitive, but an economic shock can occur when credit is expanding but the credit impulse is negative. This is what happened in 2008 in the United States.

The credit impulse also works in reverse. After a financial crisis, credit often contracts sharply at first and at a more moderate pace thereafter. For instance, if deleveraging, or the contraction of credit, is 10 percent of GDP in year one and 5 percent in year two, then the credit impulse is positive to the tune of 5 percent of GDP. That’s roughly what happened in Spain in 2013, after the euro crisis eased and deleveraging slowed, providing a pleasant surprise for investors in Spanish stocks.

Financial crises produce tantalizing investment possibilities. But investors are likely to find themselves catching a falling knife until the credit impulse turns positive. That was the lesson from the Asian crisis in the late 1990s. The trouble with emerging markets today is that credit growth still remains above nominal GDP growth. This makes a further contraction of credit more likely. A negative credit impulse over the next 12 months would likely hurt emerging financial assets.

The credit outlook for China remains particularly troubling. China’s non-financial debt now exceeds 300 percent of GDP – no relatively undeveloped economy has ever carried so much debt. Credit may not be growing as fast as it did after the financial crisis, when Beijing embarked on a debt-fuelled investment binge, but it’s still outpacing GDP growth by around 7.5 percentage points. It might seem that the risk of a negative credit impulse is particularly elevated in China. However, Beijing has preferred to let the air gently out of the credit balloon. In this respect, China is starting to look like Japan in the 1990s, where weak credit growth – rather than a sudden collapse – slowly sapped the economy of vitality.

One of the great vices of Beijing’s economic management is its reluctance to address the country’s mounting bad-debt problems. An increasing amount of China’s new credit – perhaps up to 40 percent, according to some estimates – is going to refinance and pay interest on dud loans. Over the past year, there’s been a surge in the issuance of corporate bonds and bank bills to refinance old loans. Such lending hinders rather than helps economic growth by trapping capital in unproductive uses. As China’s economy slows and the cost of servicing the outstanding debt climbs, China has entered a debt trap, according to economist Andrew Hunt.

The experience of many Asian economies after the late 1990s shows that emerging countries can stage very rapid recoveries. Investors who waited for deleveraging to start were too late to buy into the subsequent bull market in Asian stocks. But the turning point only came after credit growth had fallen below GDP growth. Today, emerging markets haven’t yet reached that juncture. Until emerging credit growth comes down in line with potential economic growth and global liquidity conditions loosen up, it’s hard to imagine a sustained emerging-markets recovery.


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