The Market after the Summer: The Emerging Epicentre of a Crisis

Equities vs bonds: buy real returns

I. de la Torre and L. Torralba (Arcano Partners) | The economist Dornbusch says that “crises take long to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine”. The events that have affected the emerging countries this summer have proven Dornbusch was right.

As usual, in our late summer report we try to explain in a very simple way the key events that have taken place in the economies and the markets over the period, so that the reader in a short time and in just four pages what cost the author tens of hours to apprehend. These are, in my opinion, the most substantial issues that have affected the economy and the market:

Turkish crisis and its impact on emerging markets

The Turkish crisis has rippled through other emerging countries that have committed the same economic errors, principally the excessive external debt in dollars. Hence, the asymmetric contagion – because the errors, are at times, of different scales –, to countries such as Russia (like Turkey, affected by recent sanctions, which have pushed the ruble down to two-year lows), Brazil (where opinion polls for the presidential election this Fall show bleak results between left-wing populism and right-wing populism), India (the rupee is at record lows partially due to its current account deficit), Indonesia, and South Africa.

All of these countries have seen the value of their currencies plummet and their volatilities rise to levels reminiscent to those of 2008, thus proving the fragility of the situation. As a collateral effect, some countries have been forced to ask for a bailout from the IMF during the past few weeks, namely, Pakistan, Angola, following the steps of Argentina and Egypt.

Moreover, the Mexican economy has entered into a contraction, but the peso partly recovered from its sharp fall, as a new agreement on NAFTA draws near before the new president starts office. Regarding Turkey, we have been warning in different reports and conferences about the biggest risks that had been developing and how a crisis could be triggered. In my opinion, the combination of a huge current account deficit (5-6% of GDP), a massive corporate debt in dollars and liras, the overdependence on the construction sector, an insufficient level of currency reserves, the sharp depreciation of its currency, and the lack of independence of its central bank will provoke a dramatic outcome.

The funding package pledged by Qatar is clearly insufficient ($15 billion vs an annual requirement of some $50 billion). Hence, sooner or later Turkey will end up following the steps of Pakistan and Angola, in my opinion; and the later, the more harmful the process. Meanwhile, the country will shift from 7% growth rates to a possible recession in 2019, a recession that could also lead to a banking crisis.

The impact of trade wars in the Chinese economy

By the end of August, the US will have imposed tariffs of 25% to a total of $50 billion of imports from China, threatening to extend to another $200 billion in autumn (Trump and Xi Jinping will hold a crucial meeting in November). Although China has announced reciprocal measures, since it exports much more to the US than it imports, its capacity to countecapacity to counteract would be more limited if the US eventually extends tariffs.

The damage to the Chinese economy begins to become more evident, not because of the direct impact on their exports, but because of the effect that uncertainty generates on their investments and as a result, on their currency (which has fallen almost 10% since the spring) and on its stock market which has dropped some 20% during the same period.

As investments weight heavily on the Chinese economy (more than 40%), uncertainty has caused the growth of investments to slow dramatically in recent months and, therefore, the impact on economic growth in the second half will be notable. This process is also aggravated by the fact that the Chinese government wisely tried to keep at bay the uncontrolled growth of shadow banking during the first semester. Yet, this decision is causing liquidity problems in many companies, which react by cutting their investment efforts. As a result, the Chinese central bank has intended to mitigate the situation, and in July, it started to inject capital into the system.

All hopes were set in consumption (which represents about 40% of GDP), but retail sales have also have disappointed. In short, if the situation does not change quickly, data from China will remain gloomy, which will accentuate the emerging crisis through lower demand for commodities (which are a crucial driver for emerging market’s exports). Their prices will bear the brunt, and especially those of industrial metals such as copper, aluminium, or zinc, which are especially sensitivity to this situation.

As an example of the above, below are two unprecedented developments:

– During the first half of the year, China’s current account balance reached negative levels for
the first time in 20 years.

– Growth in investments in China has declined to its lowest level in 20 years.

The key consideration here is to assess whether these events would produce capital flights similar to those that took place two years ago, when the Chinese and US interest rate spread dangerously narrowed. For the time being, the capital outflows have been limited, around $40 billion in the second quarter compared with $100 billion during the same period in 2016. However, the most meaningful data will be those of the summer months which will be disclosed shortly.

Reduction in global liquidity

In previous reports we have already warned that the extraordinary global liquidity seen over the past ten years would start to shrink from the second half of 2018 on. The Fed has taken a sept forward by starting to reduce its balance sheet between 30 and 40 billion dollars per month. The Chinese central bank has followed suit, at least during the first half of the year, in its fight against financial excesses.

This process will intensify next January, the first month in which the ECB will stop expanding its balance sheet. The implications are as follows:
A shortage of dollars (caused by the double effect of the contraction of the Fed’s balance and the strong increase in the US fiscal deficit, draining emerging savings), a factor that supports its currency, and which is especially harmful for emerging currencies and commodities.
The rise in real interest rates (inflation-adjusted interest rate), an issue we have dealt with in depth in the past. It entails significant risks for companies and investors given the difficulty to hedge against rising rates, as proven, for example, by the weakness of the price of gold.

 

The price of money is increasing as inflation rises

Linked to the previous point, if lower liquidity makes money more expensive in real terms, we are starting to observe the same process in nominal terms, as inflation gradually affects various economies, causing central banks to raise rates. As an example, July core inflation in the US has already reached 2.4%, which explains why the Fed has continued to raise interest rates in September (37% of SMEs state that they cannot find workers for their positions, which will speed up pay raises, something that could generate more inflation), possibly followed by four more interest rate increases in the future until short-term rates hit the 3% territory.

In turn, the depreciation of local currencies create inflation as more expensive goods are imported, a factor that explains the rate hikes that are taking place in the United Kingdom, Argentina, India, Indonesia, and Turkey (the latter by the “back door”). This phenomenon affects especially the emerging countries, since their companies have become massively indebted in the last cycle.

Perhaps the excessive emerging corporate debt is the Achilles’ heel (as well as the epicentre) of the world economy to date, so that the rate hikes could explain a relevant rise in delinquency, causing problems in their banking systems and among the investors who hold these bonds.

 

Europe at the crossroads

The economy of the Eurozone grew by 0.4% in the second quarter, less than 2% annualized, burdened by slow growth in Italy and France, but which in any case has allowed unemployment to reach 8.3%, the minimum in ten years. The situation in Italy continues to be problematic, with meagre growth, and with a government that will shortly present a budget that establishes a basic income without clarifying how it will be paid.

Meanwhile, capital outflows from foreign investors are taking place and interest is rising on their large volume of public debt (1.3 times GDP), with the 10-year bond already paying 3.1%. At the same time, the United Kingdom has begun to publish official documents advising companies and citizens of contingent plans to be carried out in the event that an exit agreement with the European Union would not be reached by its deadline (March 29, 2019).

A British minister estimated the possibilities of a no-deal at 60%, a situation that would have very harmful effects on the British economy and the already depressed pound. Regarding Brexit and its foreseeable impact on the Spanish economy, we have published an extensive report at a recent date (“The Effect of Brexit on Spain”).

 

Spain faces a slight slowdown

The Spanish economy has gone from growing at 0.7% quarterly to a 0.6%, a rate that will be maintained in the coming quarters according to the leading indicators. On the one hand, it has been the lowest growth in the last three years, but on the other hand, it is the highest rate among the largest economies in the Eurozone (Germany grows at 0.5%).

The slowdown is mainly explained by the foreign sector which has faced a deceleration in both tourism and goods (exports of goods grew by 10% in the first half of 2017, and by only 3% during the same period of 2018). In any case, the Spanish economy will grow at a rate higher than 2.5% this year, and close to that level next year, with risks, in our opinion, more than bounded. Hence, it remains a good premise of growth and risk. As we have been defending since 2014, the prices of homes in Spain will continue to rise (“The Case for Spain III: Plus Ultra”).

 

The US grows at a strong rate, but the risk of a slowdown is increasing

The US economy, triggered by fiscal incentives, grew at an annualized rate of 4.1% (which will allow the country to grow 3% this year), partly transmitted to the upward cycle of the S&P 500 (although the rise is very concentrated in certain technological stocks). However, the distinction between long and short rates, the so-called “yield curve” that signals a recession when it is reversed (when short rates pay more than long rates), has narrowed to 0.25%, the lowest level in 10 years; a flattening of the curve indicates future growth deceleration.

If this trend continues, there is an obvious risk that the curve will invert in the coming months, which could predict a recession in the US by 2020, a possible recession (or sharp deceleration) that would come from the rise in the Fed rates and its impact on excessive corporate indebtedness.

Voltaire, in the XVIII century stated: “Go into the London Stock Exchange – a more respectable place than many a court – and you will see representatives from all nations gathered together for the utility of men. Here Jew, Mohammedan and Christian deal with each other as though they were all of the same faith, and only apply the word infidel to people who go bankrupt.” Well, it seems that we will have more infidels in coming quarters, which has important consequences for the economy and the global markets.