Global Investing

The hit from China’s growth slowdown

China’s slowing economy is raising concern about the potential spillovers beyond its shores, in particular the impact on other emerging markets. Because developing countries have over the past decade significantly boosted exports to China to offset slow growth in the West and Japan, these countries are unquestionably vulnerable to a Chinese slowdown. But how big will the hit be?

Goldman Sachs analysts have crunched the numbers to show which markets and regions could be hardest hit. On the face of it non-Japan Asia should be most worried — exports to China account for almost 3 percent of GDP while in Latin America it is 2 percent and in emerging Europe, Middle East and Africa (CEEMEA) it is just 1.1 percent, their data shows.

But they warn that standard trade stats won’t tell the whole story. That’s because a high proportion of EM exports are re-processed in other countries before reaching China which in turn often re-works them for re-export to the developed world. In other words, exports to China from say, Taiwan, may be driven not so much by Chinese demand but by demand for goods in the United States or Europe. So gross trade data may actually be overstating a country’s vulnerability to a Chinese slowdown.

GS relies instead on so-called “trade in value-added” data that allows it to separate direct exports to China and indirect trade connections. Measured this way and using industrial output as a proxy for growth, emerging Asia’s effective exposure to China turns out to be half of that measured using gross trade data:

In terms of levels, a one standard deviation shock to China’s industrial production  (roughly equivalent to a 4 percent annualised growth shock) would lower the level of industrial output in non-Japan Asia by some 0.6 percent on average in 12 months from the time of the shock, so roughly by as much as the fall in China’s industrial production in that period, as per our model estimates. The average impact would be smaller for the CEEMEA countries (some 0.5 percent on average) and the LatAm countries (0.43 percent).

Bernanke Put for emerging markets? Not really

The Fed’s unexpectedly dovish position last week has sparked a rally in emerging markets — not only did the U.S. central bank’s all-powerful boss Ben Bernanke keep his $85 billion-a-month money printing programme in place, he also mentioned emerging markets in his post-meeting news conference, noting the potential impact of Fed policy on the developing world. All that, along with the likelihood of the dovish Janet Yellen succeeding Bernanke was described by Commerzbank analysts as “a triple whammy for EM.” A positive triple whammy, presumably.

Now it may be going too far to conclude there is some kind of Bernanke Put for emerging markets of the sort the U.S. stock market is said to enjoy — the assumption, dating back to Alan Greenspan’s days, that things cant go too wrong for markets because the Fed boss will wade in with lower rates to right things. But the fact remains that global pressure on the Fed has been mounting to avoid any kind of violent disruption to the flow of cheap money — remember the cacophony at this month’s G20 summit? Second, the spike in U.S. yields may have been the main motivation for standing pat but the Treasury selloff was at least partly driven by emerging central banks which have needed to dip into their reserve stash to defend their own currencies. According to IMF estimates, developing countries hold some $3.5 trillion worth of Treasuries, of which just under half is in China. (See here for my colleague Mike Dolan’s June 12 article on the EM-Fed linkages)

David Spegel, head of emerging debt at ING Bank in New York says the decision reflects “an appreciation for today’s globalised world”:

Turkey’s central bank — a little more action please

In the selloff gripping emerging markets, one currency is conspicuous by its absence — the Turkish lira. But this will change unless the central bank adds significantly to its successful lira-defensive measures.

Hopefully at today’s policy meeting.

Like India or Indonesia which have borne the brunt of the recent rout, Turkey has a large current account deficit, equating to over 5 percent of its economic output. But what has made the difference for the lira is the contrast between the Turkish central bank’s decisive policy tightening moves and the ham-fisted tactics employed by India and Brazil.  (We wrote here about this).  See the following graphic (from Citi) that shows the central bank has effectively raised the effective cost of funding by 200 basis points to around 6.5 percent since its July 23 meeting.

 

Guillaume Salomon, a strategist at Societe Generale calls Turkey the “success story” given the relatively stable lira and expects the bank to raise the upper band of its interest rate corridor by another 50 basis points at least. He says:

Russia — the one-eyed emerging market among the blind

It’s difficult to find many investors who are enthusiastic about Russia these days. Yet it may be one of the few emerging markets  that is relatively safe from the effects of “sudden stops” in foreign investment flows.

Russia’s few fans always point to its cheap valuations –and these days Russian shares, on a price-book basis, are trading an astonishing 52 percent below their own 10-year history, Deutsche Bank data shows.  Deutsche is sticking to its underweight recommendation on Russia but notes that Russia has:

“become so unpopular with the investor community that it is a candidate for the ‘it’s so bad it’s good’ club as evidenced by the very cheap valuations and long-term  underperformance.

BRIC shares? At the right price

Is the price right? Many reckon that the sell off in emerging markets and growing disenchantment with the developing world’s growth story is lending fresh validity to the value-based investing model.

That’s especially so for the four BRIC economies, where shares have underperformed for years thanks either to an over-reliance on commodities, excessive valuations conferred by a perception of fast growth or simply dodgy corporate governance. Now with MSCI’s emerging equity index down 30 percent from 2007 peaks, prices are looking so beaten down that some players, even highly unlikely ones, are finding value.

Societe Generale’s perma-bear Albert Edwards is one. Okay, he still calls the bloc Bloody Ridiculous Investment Concept but he reckons that share valuations are inching into territory where some buying might just be justified. Edwards notes that it was ultra-cheap share valuations in the early 2000s that set the stage for the sector’s stellar gains over the following decade, rather than any turbo-charged economic growth rates. So if MSCI’s emerging equity index is trading around 10 times forward earnings, that’s a 30 percent discount to the developed index, the biggest in a very long time. And valuations are lower still in Russia and Brazil.

“Contrarian” Deutsche (a bit) less bearish on emerging stocks

For an investor in emerging equities the best strategy in recent years has been to take a contrarian stance, says John-Paul Smith at Deutsche Bank.

Smith, head of emerging equity strategy at Deutsche, has been bearish on emerging stocks since 2010, exactly the time when bucketloads of new cash was being committed to the asset class. Investors who heeded his advice back then would have been in the money — since end-2010 emerging equities have underperformed U.S. equities by almost 40 percent, Smith pointed out a couple of months ago.

Things have worsened since then and MSCI’s emerging equity index is down around 12 percent year-to-date, almost the level of loss that Deutsche had predicted for the whole of 2013. June outflows from emerging stock funds, according to EPFR Global last week, were the largest on record. But true to form, Smith says he is no longer totally bearish on emerging equities.  Maybe the presence or absence of those he calls “marginal international investors” — people who joined the EM party too late and are quick to take fright — is key. Many of these positions appear to have been cleaned out. Short positions or high cash balances dominate the books of dedicated players,  Smith writes:

A drop in the ocean or deluge to come?

Glass half full or half empty? For emerging markets watchers, it’s still not clear.

Last month was a record one in terms of net outflow for funds dedicated to emerging equities, Boston-based agency EPFR Global said.  Debt funds meanwhile saw a $5.5 billion exodus in the week to June 26, the highest in history .

These sound like big numbers, but in fact they are relatively small. EM equity funds tracked by EPFR  have now reversed all the bumper year-to-date inflow registered by end-May, but what of all the flows they have received in the preceding boom decade?

No more currency war. Mantega dumps the IOF

Brazil’s finance minister Guido Mantega, one of the most shrill critics of Western money-printing, has decided to repeal the so-called IOF tax, he imposed almost three years ago as a measure to fend off  hot money flows.

Well, circumstances alter cases, Mantega might say. And the world is a very different place today compared to 2010. Back then, the Fed was cranking up its printing presses and the currency war (in Mantega’s words) was raging; today the U.S. central bank is indicating it may start tapering off the stimulus it has been delivering. Nor is investors enthusiasm for emerging markets what it used to be.  Brazil’s currency, the real, is plumbing four-year lows against the dollar and local bond yields have risen 30 basis points since the start of May. Brazil’s balance of payments situation meanwhile, is deteriorating, which means it needs all the foreign capital  it can get, hot money or otherwise. And currency weakness spells inflation — bad news for Brazil’s government which faces voters next year.

The IOF did work — Brazil’s local debt markets received just over $10 billion last year, Bank of America/Merrill Lynch calculates — a third of 2010 levels, and much of the cash that was already invested, preferred to stay put (given the IOF is paid upon exiting the country).

Emerging markets to fuel airline spending trajectory

Emerging markets may not have all the technological know-how in civil aerospace, but from China across the world to Brazil, they do have the cash.

The civil aerospace sector performed well in 2013, according to Societe Generale data, trading at a 4 percent premium over the MSCI world index, while the defence sector has steadied, and in the medium to long term civil aerospace should be supported by strong orderbooks from emerging economies.

Research from PwC shows the global aviation industry is set to increase by 3.3 percent to 68 billion by 2022, driven by an increase in fleet size.

Japan’s big-money investors still sitting tight

More on the subject of Japanese overseas investment.

As we said here and here, Japanese cash outflows to world markets have so far been limited to a trickle, almost all from retail mom-and-pop investors who like higher yields and are estimated to have 1500 trillion yen ($15.40 trillion) in savings. As for Japan’s huge institutional investors — the $730 billion mutual fund industry and $3.4 trillion life insurance sectors — they are sitting tight.

If some are to be believed, the hype over outflows is misguided. Morgan Stanley for one reckons Japanese insurers’ foreign bond buying may rise by just 2-3 percent in the next two years, amounting to $60-100 billion. Pension funds are even less likely to re-balance their portfolios given large cash flow needs, the bank said.

But a Reuters survey last week revealed several insurance companies are indeed considering boosting unhedged foreign bond holdings.  Insurers currently hold almost half their assets in Japanese government bonds and risk being crowded out of the JGB market as the central bank ramps up purchases.  A recent survey by Barclays also showed Japanese investors keen on overseas debt.