While some disagreement still exists among investors about the degree of weakness of emerging market fundamentals, most investors are now fully aware that there is an endogenous emerging market problem, created by more state interventionism in the economy and excessive credit growth over the past 10 years.
Also well flagged are the two main global factors that put most pressure on emerging market growth and emerging market assets: the Chinese slowdown and the normalisation of US monetary policy. Since 2010, we have seen Chinese demand growth slowing and the risks of a disorderly unwinding of the Chinese growth miracle increasing. This has had a continuous negative impact on the emerging markets that trade most with China, most prominently the commodity exporters.
Since 2013, when the US tapering concerns began, the unwinding of the US dollar-emerging market carry trade has put additional pressure on emerging markets. This theme has flared up several times in the past years, every time when investors became more worried about Fed policy tightening.
The recent period of sharp emerging market equity underperformance can be explained by increased concerns about Chinese growth and policy action by the Chinese leadership. Nervousness about the first Fed rate hike and more capital outflows from emerging markets has played a less prominent role in July.
At the same time, we have seen the theme of endogenous emerging market weakness playing a bigger role than before. A growing group of relevant emerging economies has come under severe pressure due to the combination of collapsing raw material prices, capital outflows, increasing stress in the financing system, insufficient policy response and rising political risk.
For the first time since 2002, emerging market credit risk is clearly back on the table. China, with its unparalleled leverage growth, should be watched with the utmost caution and remains the number-one candidate for a credit crisis in emerging markets.
However, next to China, other countries look increasingly vulnerable from a credit perspective. Thailand, Brazil and Turkey all have enjoyed a credit boom, which now looks increasingly unsustainable due to the changing global liquidity environment, the rapidly deteriorating economic-growth picture, the depreciating currencies and the growing signs of system stress.
In other countries, where total leverage growth has been less, signs are emerging that banks are dealing with serious credit problems. News of bad debts in Korea’s shipbuilding industry and in Taiwan’s local governments are worrying in the current emerging market environment. Risks for the financial system that are difficult to quantify also originate from the large corruption scandals that are currently raging in Malaysia and Brazil.
Let’s move back to China. What has made things worse in recent months is the correction of the stockmarket and, more importantly, the desperate attempts of the authorities to stabilise the market. The intervention of the government, that may have prevented a sharper correction, has created more doubts about the free-market direction of overall Chinese government policies.
On top of this, it has caused more doubts and concerns about the state of the Chinese financial system. Why would the authorities find it necessary to take such draconic measures. It suggests that the problems in the banks, with bad debts in the real estate, construction and construction materials sectors, are bigger than generally thought.
That equity market refinancing of debt is more urgently required. Or that the economy is much weaker than generally perceived and that the government is afraid of a deeper confidence crisis making the slowdown uncontrollable. All in all, the China risk has increased, also because the statistics that are considered most credible, continue to suggest that the slowdown is still accelerating.
As China created more nervousness about emerging market assets, it has pushed the Fed risk to the background. The Chinese situation has likely been one of the reasons why there has been downward pressure on developed market bond yields recently.
This is unlikely to continue. The Fed has made it clear that they want to start raising interest rates before the end of the year. At the same time, capital flows to the riskiest, most capital-hungry emerging economies have remained positive, despite a clear deterioration in macro fundamentals. As the US will continue to normalise its monetary policy, pressure on emerging market flows is likely to intensify.
Together with the unwinding of the Chinese growth miracle, this remains the biggest threat to emerging market growth and all emerging market assets.
Maarten-Jan Bakkum is senior emerging markets strategist for the multi-asset team at NN Investment Partners.