If a blizzard of awful Chinese economic data is not enough to convince you that China is heading into a deflationary slump and the commodity "super-cycle" is coming to an end, then the deepening crisis in the eurozone should be. That's because not only will a massive reduction in foreign lending by European banks hurt investment in emerging markets, but supplier economies will be hit disproportionately, as they were post-Lehman.
In an increasingly interdependent global economy, it was always disingenuous to suggest that emerging markets could de-couple from the developed world, given their dependence on exports. But fund managers were all too willing to suspend their disbelief, as a liquidity-driven investment boom sent commodity prices soaring.
However, with fixed asset investment -- which accounts for 50% of GDP -- collapsing in China, global demand for non-food commodities will plummet, argues Michael Pettis of Peking University. After all, China's share of global demand for such commodities as iron, cement and copper is almost wholly a function of this high level of investment. Moreover, commodities are notorious for going through periods of scarcity and glut. Having increased production massively since 1999 -- crude oil output has risen by 16%, copper by 28% and aluminum by 94% -- it certainly feels like the end of the cycle.
The multinational mining, oil, and gas company, BHP Billiton (BHP), agrees. It expects commodity markets to cool further and has put the brakes on a plan announced in 2011 to spend $80 billion over five years to expand its iron ore, coal, energy and base metals divisions, banking on continuing high demand from its main market, China.
Some die-hards, like Morgan Stanley (MS), cling on to the hope that there will be some kind of turnaround, and that China can stimulate its economy. Cutting interest rates will do no more than push on the proverbial piece of string though, as the Chinese are queuing up to pay down their debts. Besides, the Chinese government is in no mood to reflate a property bubble it has done so much to deflate.
Meanwhile, with European banks being forced to shrink their balance sheets, and under strategic and political pressure to lend close to home, new syndicated bank lending to emerging markets dropped 51% to $105 billion in the first quarter of 2012. But this is only the beginning. If European bank lending abroad fell 37% after the collapse of Lehman Brothers, then how much will it fall if most of Europe's banking sector ends up being nationalized?
Eastern Europe, where Austria, Italy, and France typically own 60-90% of bank assets, is particularly vulnerable in this respect. But so is Asia. European banks may only contribute around 10% of the financing needs of Asia's markets, but the 5.9% fall in the consolidated claims of European and U.K. banks on Asia in the fourth quarter of last year was enough to cause an acute shortage of dollars, rising interbank rates, and downward pressure on emerging market currencies.
Supplier economies such as Taiwan, Korea and China, and commodity suppliers such as Canada, Australia and Brazil, are now highly vulnerable to the "bullwhip effect" in global supply chains. As we move away from the consumer, even small fluctuations in consumer demand get amplified up the supply chain into big swings in demand. This is why a severe recession in Europe is also likely to translate into a collapse in raw material prices, and why hedge fund contrarian Hugh Hendry describes the BRICS as "vastly over-vaunted and over-owned."
Looking ahead, old patterns of trade and growth will have to change. It's the end of Chinese, German, and Japanese mercantilism, as every country competes aggressively for a share of global markets, argues Nobel prize winning economist Joseph Stiglitz; "Of course, not everyone can run surpluses, so this becomes a game of hot potato, with everyone pushing the deficit to someone else, via currency devaluation and other aggressive trade moves."
The terms of trade are shifting in favor of commodity importing countries -- which will be a blessing for the U.S. and Europe -- given that a system in which they are the "deficit of last resort" is not sustainable. As Europe is also likely to see some highly competitive economies emerge from the ruins of the euro, going short its financial sector and long its export sector could be a highly profitable trade.
Unable to grow on the basis of rapid exports to Europe and the U.S., Asia will have to focus on trading more with other developing regions like Africa and Latin America, in addition to a much more domestic-centered strategy through regional trade groupings such as Asean, which is moving towards a unified market in 2015.
Whatever happens, the sharp contraction in international and capital imbalances is likely to be a wild ride; one which Lakshman Achuthan, of the Economic Cycle Research Institute has dubbed the "yo-yo years."
In the meantime, investors should short the BRICS (BIK), the Canadian dollar (FXC), and the Australian dollar (FXA) as global investors have already begun to aggressively cut back on their BRIC exposures, judging by capital outflows from these countries.
Lower commodity costs and cheaper products from China will benefit the U.S. consumer, so investors might want to start believing in a sustainable U.S. recovery.