The taper has finally started and equity managers globally will be working on (and perhaps re-assessing) where to put their money to work going into next year. There's a strong case that the money which has flowed into developed markets this year will start to switch into emerging markets in the short-term. Particularly if stocks start to "melt up".
The attractiveness of emerging markets, particularly Asia, is obvious enough: 1) easy money is here to stay for a long time, benefiting these markets. 2) they've significantly under-performed developed markets over the past 18 months. 3) asset managers are underweight emerging markets, meaning even a small switch could have a major market impact 4) these markets trade at substantial valuation discounts, particularly against the S&P 500.
I think that any short-term bounce in emerging markets though - and the focus here is the largest of these markets, Asia - should be treated with caution. There are increasing, albeit anecdotal, signs of corporate distress in China. These signs point to a gradual unwinding of China's credit binge and are likely to weigh on growth in the world's second largest economy. This will hurt key commodity exporters, including Indonesia.
Also, Japan has signaled more QE is on the way there, which will put downward pressure on the yen and continue to negatively impact key Asian exporters, such as South Korea and Singapore. Tepid growth in the West won't help these exporters either. Finally, other Asian countries are dealing with their own internal issues, such as Thailand (politics) and India (inflation). All of this points to a continued slowdown in economic growth in Asia next year, possibly putting a cap on corporate earnings and stock market performance in the region.
The case for a short-term pop
We won't go into the details of the taper announcement, as you can get plenty of that elsewhere. But the rub is easy money via loose policy is likely to be with us for a very long time. The tapering of US$10 billion per month is peanuts in the grand scheme of things. And it's clear the Fed wants to keep interest rates low for a lengthy period. Equity markets have rightly interpreted the moves as favourable to risk assets.
In simplistic terms, there are three ways for stock markets to go from here:
- You get a melt-up as retail investors, who've been dipping their toes back into the market, start to go all in.
- There's a short-term correction as markets have a breather after a good run, and over-sold bond markets see some love.
- There's a sharper correction, anticipating economic weakness.
It seems to me that the odds favour either 1. or 2., at least in the short run. And under these two scenarios, investors will be asking themselves where to place their equity bets. With the U.S., Europe and Japan having had stellar runs, some will stick with the momentum in these markets. I suspect many others will begin to look for laggard markets to play catch-up. And that's where emerging markets come into the equation.
There are several other factors in favour of emerging markets besides just under-performance, such as:
- If rates do stay low during the taper, that'll benefit emerging markets. The worry has been of rising rates impacting the ability of countries with large current account deficits to fund these deficits.
- Global investors are significantly underweight emerging market stocks. A small switch into these stocks could have a large impact.
- Emerging market valuations are at a steep discount to the rest of the world. On a 12-month forward PER basis, emerging markets trade at a 27% discount to global markets.
Why caution is warranted though
There are several reasons to treat any short-term bounce in emerging markets with some skepticism though. One key reason is that serious cracks have started to appear in the world's second largest economy, China, and few have been paying attention. If these cracks gradually widen, as I suspect, the impact will first be felt in emerging markets and then globally.
Now it must be said that markets are giving mixed signals on whether there are increasing risks of a credit bust in China. A spike in China inter-bank rates and the plummeting Aussie dollar and Indonesian Rupiah suggest cause for concern. On the flip side, China stock markets and key indicators such as copper and iron ore prices have been behaving reasonably well.
But consider some of the key economic indicators released recently:
- The December Flash PMI reading for China slowed to a three-month low, suggesting a softening manufacturing sector.
- CPI growth declined to 3% in November, but more tellingly PPI (producer prices) fell 1.4%. The latter is of concern as it indicates excess manufacturing capacity, or dumping excess goods on the rest of the world, in non-economic parlance.
- Credit continues unabated, most of which remains in the murky trust loan space (these have subprime-like structures).
- The flow of credit continues to help the bubbly property market, with residential real estate prices increasing 9.9% in November, the fastest rate of growth for 2013. So much for the government wanting to slow price increases!
More worryingly, there are increasing anecdotal signs of corporate distress in China. The latest story is of Liansheng Resources Group, a coal mining company which has ended up in court owing 30 billion yuan ($4.9 billion) in debt, much of it from the so-called shadow banking system (trust loans and so forth). It follows news that China Everbright Bank defaulted on a 6.5 billion yuan ($1 billion) loan in June, though it only disclosed this in a prospectus this week. These are just a few of many stories of corporate distress, much of it in the mining and construction sectors, in recent months.
In sum, you have slowing growth, falling inflation, booming credit outside of the banking system, property prices continuing to climb despite government efforts to tame them, bad debts ticking up and lots of stories of corporate distress.
Are these signs that China is on the verge of a more substantive credit bust? Perhaps. Like many countries today, China has a debt problem. Though that debt isn't as large as many developed countries (about 220% total debt to GDP), it's the speed at which it's increased which is a concern. The majority of the debt is in the corporate sector (125% of GDP), where the distress is starting to be felt.
Much of the corporate debt though has been rolled over, thereby delaying the recognition of bad debts. The upshot is that this recognition may take several years to play out. That could well weigh on economic growth in China for some time to come. And that, in turn, may slow growth in the rest of Asia.
There are other risks to economic growth in Asia besides China. Just two weeks ago, we suggested even more QE was on the way in Japan. And sure enough, Japan's central bank said this week that it sees significant scope for boosting stimulus. That's code for: it's coming at any moment now. This shouldn't come as a surprise given weakening economic momentum in Japan. The record trade deficit in November further highlights that Abenomics isn't working. But Japanese policymakers think that if QE hasn't worked, there needs to be more of it! The implications of this are that Japan will embark on further extraordinary policies to kick-start its economy. All in an effort to boost inflation by weakening the yen.
A weaker yen will make Japanese exporters more competitive against key rivals. Those rivals in Asia include China, South Korea, Taiwan and Singapore. Until these countries fight back with currency depreciations of their own, their export-oriented economies will suffer.
Finally, there are Asian economies with what may be best termed as idiosyncratic issues. India is dealing with the vicious combination of slowing economic growth with still rising inflation. You shouldn't expect any significant policy changes until after the general elections in late May. And there's also Thailand, where political trouble has again ignited, with early elections called for February next year. The current Shinawatra government has lasted 2.5 years, a lengthy period in Thai terms. Deep political divisions clearly remain and that may mean further sub-par economic performance.
Will slower Asian growth flow through to markets?
The big question is this: will slower economic growth in Asia cap stock market performance in the region? To that question, I don't have a certain answer. Weaker economic growth usually weighs on corporate earnings. Though there are numerous factors which impact earnings, of course. And corporate earnings are one half of the price-to earnings multiple paid for markets. The other half relates to price and that's the tricky part-- anticipating what multiple investors will be willing to pay for these earnings. For instance, about 80% of the rise in the S&P 500 this year has come from investors being willing to pay a higher multiple for still meek U.S. corporate earnings.That may well happen in Asia too. But the odds seem to be against it.