Structural headwinds for Emerging Markets

August 26, 2015

A common misbelief among investors is that economic growth and equity market returns are positively correlated. Faster growing economies generate faster earnings growth and that must be good for investors… right? Wrong.

It ignores 3 important factors (1) companies typically issue large amounts of new equity to finance the growth such that earnings per share growth (not earnings growth) suffers badly (2) the benefits of company growth can accrue to three alternative agents: investors, managers and/or employees. Often, once managers have paid themselves, employees have received pay rises and the company goes on an investment spree, there is little or nothing left for the poor old investor standing patiently at the back of the line and (3) investors often overestimate growth and overestimate the durability of growth, extrapolating rapid growth into the horizon when we know that mean reversion is an important feature of all economic activity.

Nevertheless, for as long as investors suffer the cognitive dissonance of believing in growth miracles (China has been the best, delivering miserable returns to “apparently” rampant economic growth over the last two decades) it is important to look at the structural underpinnings of Emerging Market growth.

Two simple charts illustrate the huge structural headwinds facing Emerging Markets in the next five years or more that will, over the course of the cycle, overwhelm any benefit that might accrue from near term currency devaluation:

  • Firstly, we can see that the “Growth Gap” between Emerging and Developed Countries is very highly correlated with the scale of deficits run in the Developed World. The rapid acceleration of EM growth versus the West in the period 2000 – 2008 (that gave rise to endless stories about the sclerotic Developed World giving way to China and Emerging Economies, that Emerging Economies would dominate economically and politically within a few years, that investors need only follow the path to the East to find riches) was driven purely and simply by unprecedented Developed Country deficits.
  • The EM growth boom was “Made in the Developed World”


  • Secondly, this ballooning Western deficit promised eternal reward and investment surged in the Emerging Markets to build capacity to meet the promise of endless demand:
    • Investment as a % of GDP in the Emerging World exploded from 25% to 31% in just about a decade.


    • Sadly, just as investment reached levels unprecedented in the last century, demand evaporated as the Developed World deficits evaporated (a $650 billion swing since 2008).


  • This means Emerging Markets have been left out on a limb – unprecedented investment with no apparent demand… Mind the Gap.


What does it mean?

  • Investment/GDP ratios in the Emerging Markets must fall sharply in the next 5 – 10 years, back to levels prevailing prior to the run up after 2000. That means much slower growth structurally. To think that the fabled “Emerging Consumer” can step in is without justification.
  • The disappearance of the Developed Country deficits means a disappearance of US Dollars and that implies tighter conditions domestically, compounding the adjustment in investment. In other words, the growth rate in International Foreign Exchange Reserves (the counterpart on the Central Bank balance sheet to the growth in domestic currency liquidity) will slow rapidly and in due course, as in China, reserves will flow away rapidly. Rising reserves imply easier domestic policy conditions, falling reserves imply tighter domestic policy conditions.
  • Weaker currencies and, in some cases, lower interest rates can cushion the blow but the headwinds are far too strong to be resisted domestically. Emerging Market growth will go back to levels little different from the Developed Countries, as was the case prior to 2000. If “growth is your thing” that’s not an appealing prospect.
  • Having been out of EM Equities for the last two years we would not anticipate re-entering anytime soon.



Implications of the China Crisis…

August 24, 2015

While in many cases a 38% decline in Equities from their mid-June peak, wiping out 16 months of gains in just 8 weeks, might have had substantial domestic economic effects – not least through the wealth loss in the Private Sector – the consequences of the decline in the Chinese market are slightly more subtle and global in nature.

A little background data might prove helpful; according to the China Household Survey of Finances, about 9% of Households participate in the Equity Market and Equities account for just 1% of Total Household Financial Assets. In comparison, Japanese, Euro and US Households have 10%, 18% and 33% of their Financial Assets in Equities. The loss of wealth and the direct effect on consumption in an economy of approximately $10 trillion and where Household Consumption is just 38% of GDP (versus 52% back in 1990) is, by any measure, modest. Moreover, the top quintile of Households by Income own over 90% of the Equities held by all Households and they have the lowest propensity, by far, to consume. China is just a little bit different.

So, what is the most worrying element of this whole affair?

As we have shown previously, the real problem of China lies in the fact that Manufacturing Productive Capacity Growth still substantially exceeds the rate of growth in demand globally. Domestic demand in the Euro area, UK, Japan and US is growing at just about 2.5% when Chinese Manufacturing Capacity is growing at almost four times that pace.

The gap is narrowing rapidly, and that is the source of the rapid slowing in Chinese growth, reflected in commodity prices, global growth and global inflation. However, it is still substantial and the excess that has been accumulated will take years to run-off.


The consequence of this huge overhang in potential supply is very clear when you look at the growth rate of Global Merchandise Trade in the last decade:

  • China accounts for a fifth of the growth in Global Merchandise Trade in the 10 years through 2013, with the Asian bloc as a whole at 43% (22% if we strip away Japan and China).
  • At the margin, China (and Asia) have made a hugely disproportionate contribution to the growth in World Trade in the last decade. In that period, global production rose 2.7% annually when trade grew 4.7% annually.
  • In the 5 years up to 2013, China accounted for 27% of the growth in Global Merchandise Trade.


In short, World Trade Growth has substantially outpaced production growth in the last decade and China has been a disproportionate contributor to that trade growth. China is the marginal provider of cheap goods – it is, in effect, the price setter in the global market for merchandise.

Now, if we add a devaluation to a massive overhang in capacity and the role of China as the marginal price setter globally, what do we get? Disinflation and Deflation.

China’s “out” from this slowdown – driven by years of debt accumulation, bank balance sheet expansion and grotesque over investment – is devaluation. The implication for the West is clear – deflation. This makes an exit from QE and a normalization of monetary policy almost impossible.

What is the impact of deflation on Equity markets?

Well, take a look at the following chart. We took one of the most reliable and commonly used valuation ratios – the Price/Trailing 10 Year Earnings – and looked at it over the last century and more versus US Consumer Price Inflation. You see something very interesting:

  • Over the whole period there is, as some have noted, a “sweet spot” for valuation – the blue bars have a distinct “hump” at the 5th and 6th inflation decile, which is when consumer price inflation is in the range 2.0 – 3.3%.  Note that valuation falls away quite appreciably when we get down into zero inflation and below that in the lower two deciles.
  • There is, however, some relief when we exclude the extraordinary period of the last 20 years and the bubble of 2000. Then we see that the “sweet spot” is, in fact, a consequence of a small number of observations around the 2000 bubble peak. Nevertheless, valuations do fall away noticeably at very low inflation/deflation periods (and at very high inflation levels).


So, if our analysis is correct and we face a period of intense disinflation/deflation, then a lower valuation for Equities would appear entirely appropriate. In the meantime, reluctant to pin all hopes on a forecast, we continue to “observe and infer” i.e. to respond to changing market conditions rather than try, frustratingly, to anticipate them.



UK inflation… widespread disinflation

August 18, 2015

While people generally focus on the headline number, the more useful information, as always, is contained in the detail of the index. We look at the 80 main sub-components of the index to see if there is any uniformity in the trend for inflation seen at the headline level. Any reversal in trend will be evident at the sub-index level first:

  • Of the 80 components, 50% have deflation over the last 12 months, looking back over the last decade (and more) that is an extraordinary degree of price deflation.


  • Of the 80 components, 65% have inflation below 1% over the last 12 months and 78% have inflation below the 2% level in the last 12 months.



  • Most importantly, 70% of the sub components in the UK inflation index have seen their rate of inflation decline in the last 12 months.

There is simply no sign, at this point, of any latent inflationary pressure. Indeed, the Chinese devaluation (the beginning of a trend), persistent global oversupply (compounded by ongoing over investment in China and the Emerging Markets) and the weak global growth environment all suggest disinflation and deflation are the greatest risk.


There is little evidence here for the Bank of England to justify a rise in interest rates. However, there is more justification elsewhere should the Bank be keen to press ahead:

  1. The private sector in the UK is running a financial deficit of 1.5% of GDP (i.e. its Gross Investment > its Gross Savings) meaning that the private sector, like the public sector, is accumulating net liabilities. This is the first time we have seen this in the private sector since 2002. The economy is accumulating debt at a rapid pace.
  1. The average house price/income ratio now stands at 5.3x and is at 6.5x in the Southeast and a record 7.8x in London. In fact, of the 9 UK regions, all have a price/income ratio above 4 (and 44% above 5).
  1. The UK is running a record current account deficit of 6.2% of GDP (this is not a consequence of a peculiarly British ability to hold very low yielding foreign assets, as some have suggested). With only modest Fiscal Tightening in recent years and the private sector going into deficit, the UK has provided the deficit that, from an accounting position, is the counterpart to the improved deficits/surpluses now being run in many of its trading partners. The final chart shows the change (as a % of GDP) in the UK Current Account since mid-2009 compared with that of the major blocs/countries around the world:

Both China and Japan have seen their surpluses decline sharply as the global economy has corrected. The UK has seen its deficit widen sharply as the Eurozone and US have improved their external positions materially.

You could say the UK, and the UK consumer, has helped hold the world up in this difficult period.


All told, overvalued housing markets/large current account deficits (private and government sector deficits) have been a warning sign in many a crisis around the world and especially in the UK. The Bank of England will find more justification here than in the inflation data.

Do you tighten to have an impact on something you can influence i.e. domestic credit conditions or tighten to have an impact on something you cannot influence i.e. the massive overhang of global productive capacity and easier Chinese monetary conditions?



The Problem of China…

August 12, 2015

(with apologies to Bertrand Russell, “The Problem of China” published in 1922)

When Bertrand Russell published his fascinating observations of China, its role in the world, relationships with its neighbours and prospects for growth, little did he know that almost a century later China would still represent an enormous challenge for the West.

While the devaluation of the Yuan in recent days has been surprising in its timing, it is a policy shift that we have expected and written about for quite some time and reflects the big problem that is China. Here are 4 reasons to expect a sizable Yuan devaluation over the next year or two:

1.  Major Chinese financial institutions are expanding their balance sheet at a rate equivalent to 35% of GDP annually. If we, conservatively, expect half of those assets to be non-performing (perfectly prudent by historical standards) and apply a 50% recovery rate to the losses then the financial system is writing off an amount annually equivalent to 9% of GDP (that is approximately estimated as  (0.5 * 35%) * 0.5 = 8.75%). Think about that number carefully, if you believe (and we don’t for a second) Chinese GDP growth numbers, then the economy is actually contracting: 7% GDP growth less 9% write-offs.


Summary of Point 1 = The Chinese economy is,  and has been for some time, in outright contraction/recession.


2.  The capital stock of the Chinese manufacturing sector is expanding at a 10% year/year rate. That contrasts with a 31% median annual growth rate in the ten years through 2013.  Unfortunately, domestic demand in the USA + Euro area+ Japan + UK is growing just 2.5% year/year.


Summary of Point 2 = China is adding capacity to supply goods way faster than demand is growing. That means increasing amounts of idle and costly capacity in China. When supply growth rapidly outpaces demand growth it means only one thing… deflation. China is slowing capacity expansion, which is slowing growth, but the gap remains enormous and suggests a huge deflationary pulse is headed west as the capacity finds sales. The impact of much, much slower investment growth has to be cushioned… by devaluation.


3.  The Chinese Yuan has appreciated in real, effective terms by 11-15% in the last year (depending on whether you apply a consumer price or producer price deflator). For an economy in contraction/flat at best, with rapid capacity expansion, a corporate sector that is grotesquely leveraged by international standards and sits atop wafer thin/non-existent profit margins… that’s a big problem.

Yuan appreciation on this scale is almost unprecedented and Chinese industry just does not have the ability to withstand it…


Summary of Point 3 = The Chinese Yuan has appreciated on an almost unprecedented scale and the strength of the USD, with a policy tailwind behind it as the Fed presses to normalize interest rates, makes it unbearable. Lower interest rates in China, changes to Reserve requirements in China or any other monetary policy changes in the Western style are ineffective. Devaluation is the only way out.


4.  China is haemorrhaging foreign exchange reserves. Over the years capital flowed into China, chasing the “miracle”, and the Chinese central bank purchased those foreign currency inflows and in return provided Yuan liquidity – the central bank increased its assets and had a corresponding increase in its liabilities in the form of Yuan liquidity. The growth in reserves fuelled the economy.

With a former Trading Manager responsible for the UK Foreign Exchange Reserves at our firm, this is an issue close to our heart.

Now, in the last 4 quarters, China has lost $299 billion in reserves. This represents an effective tightening in domestic monetary conditions on an enormous scale. As if Yuan appreciation were not enough, this makes policy conditions much, much more restrictive just when the economy is floundering.


Summary of Point 4 = A huge loss of international reserves represents a substantial tightening in monetary conditions, on top of the real appreciation in the Yuan.


What are the implications for the West?

Well, just take a look at the UK Consumer Price Index to see what looms.

Over half of the index components have already deflated over the last year, and that is before the Chinese devaluation trend kicks in.


Fully 83% of the index components have inflation in the last 12 months below 2%.


Moreover,  75% of the index components individually have lower inflation rates today than a year ago.

A Chinese devaluation cycle is only going to compound the existing trend.

The Bank of England might want to normalize interest rates to deal with the record current account deficit. Private sector financial deficit and grossly overvalued housing market will face a challenge in coming months/quarters.

Do you deal with monetary sector inflation or do you deal with real economy deflation/disinflation… ?

Either way, a desire on the part of the Chinese to devalue (and they need significant devaluation) probably means less of a desire in the UK and US to tighten policy. Monetary liquidity conditions are likely to remain more accommodative for longer and there is a non-negligible risk that another round of QE might be necessary to counter the Chinese move. Monetary policy competition between the Bank of England, the ECB, the Fed and the Chinese.

This is what the world looks like when you have one tool – QE – and you use it to abandon… “The Problem of China”!