Investors Eye Emerging-Market Corporate Zombie Debt Spreads And Their Exposed EU Bankers

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Includes: ADRE, DBEM, EDBI, EDC, EDZ, EEM, EEME, EET, EEV, EMEM, EMF, EMLB, EMSA, ESGE, EUM, EWEM, FEM, FLQE, HEEM, IEMG, KEMP, KLEM, MFEM, MSF, PPEM, RFEM, ROAM, SCHE, SPEM, VWO, XSOE
by: Gordon Long
Summary

QE and developed economies' central bank policies of easy money have distorted and corrupted the global supply chain.

The inevitable outcome was clearly evident in 2013-2015 but effectively ignored by the corporate global supply chain players in an Emerging Market race to capture economic growth.

Corporate debt loads are the central problem this time for EM, not just the typical sovereign debt levels which have historically triggered crisis. This has important investment opportunities for investors.

This time around it is not about an emerging-market country crisis (i.e. Thailand, Mexico, Argentina, etc.) but rather a global swath of troubled EM countries.

The resulting U.S.-dollar-denominated debt and weakening demand, along with shrinking liquidity, has EMs trapped, unless the dollar falls, demand increases, or QT is halted and reversed.

There is a second banking crisis looming in the EU as the Emerging Market turmoil washes ashore to where much of their burdensome debt originated. Like the PIGS (Portugal, Italy, Greece & Spain) and Cyprus in the first EU banking crisis of the earlier part of this decade the problem stems from once again over-leveraged European banks. However, the problem has become more intractable as it involves a never experienced before post QE "demand gap"; the explosion of global supply chain driven corporate debt and the near entire global Emerging Markets sector.

THE ECHO BOOM

We laid out what the Emerging Markets' problems would eventually be as a result of Quantitative Easing when we did a series of UnderTheLens videos beginning in 2013 entitled “The Echo Boom” (here & here). The serious concerns currently evident in the emerging markets should be seen as the consequence of Global Monetary Malpractice which we highlighted and warned of at that time. What we have subsequently experienced once again (with a major twist) is the four historic and problematic cornerstones of Emerging Market economies which we felt would no doubt once again unfold over time and which we based our Echo Boom Thesis on:

THE FOUR CONSISTENT EMERGING MARKET POLICY MISTAKES:

  1. Allowing "Fast Money" to easily enter an economy and disrupt policies of Sound Money,
  2. Allow excess capacity build-out with potential resulting "over-supply" and lost pricing power,
  3. Over expose a sovereign economy to the cardinal sin of the Carry Trade of borrowing in Foreign Currencies,
  4. An inability to control the dependencies that low value add product contributions to the Global Supply Chain encompass.

THE SUPPLY CHAIN DISTORTION

Quantitative Easing and the Developed Economies' Central Bank Policies of "Easy Money" distorted & corrupted the global supply chain. The inevitable outcome was clearly obvious in 2013-2015 but effectively ignored in a race to capture economic growth and global market share.

  1. QE brought demand forward and consequentially increased supply,
  2. Cheap central bank money allowed global build-out in production capacity,
  3. Global over-capacity resulted in lost pricing power,
  4. The "hole" from bringing demand forward has created a demand slowdown further aggravating the pricing power,
  5. Countries with negative Current Accounts have had their currencies crushed,
  6. Weak currencies has forced their central banks to increase interest rates,
  7. These shifts are creating a new wave of "Zombie" Corporations who are being forced to increase prices to survive or seek government relief (i.e. Turkey's new "Bad Bank" solution).

DEBT HELL

Hell is defined in the business of international finance as being too heavily leveraged in a period of rising rates and slowing trade with your debt denominated in a rising currency. This trap has again been sprung and financial vultures are circling the EM's looking for easy "discounted" corporate prey and rising spreads. I may be too harsh in this statement but this playbook is well understood by bond investors who aren't susceptible to the Wall Street "millennial army" packaging trading advise for newbie investors.

IT IS HELL OUT THERE!

A DIFFERENT TYPE OF DEBT PROBLEM

Why this is an even bigger investment opportunity this time around is that the poorly understood "twist" with this Emerging Market Crisis is about corporate debt load levels versus simply the traditional excess EM Government Debt levels that have historically triggered a crisis.

A massive hidden threat to EM's is the rampant growth in "Zombie Corporations" which the Bank of International Settlements continues to warn about.

  • Over 10% of Global Corporations are "Zombies" according to the BIS Quarterly Report (where EBIT is smaller than their interest expense),
  • Over 20% of Global firms are now considered "Challenged",
  • A significant and growing number of both of the above categories are appearing in Emerging Markets as global trade slows, roll-over debt rates rise and margins are squeezed.

Additionally and maybe most critically for investors is that this crisis is across the entire Emerging Markets sector, not a single poorly managed country.

HELD HOSTAGE

The Emerging Markets and their corporate firms are presently held hostage to four factors which are more or less out of their control:

  1. A Strong US$,
  2. Shrinking Euro$ availability,
  3. Slowing Global trade and Economic growth,
  4. Shrinking Global Liquidity from reduced central bank easy money and quantitative tightening.

As a result of the above corporate spreads are likely to continue to deteriorate and EU Banking problems are likely to rapidly deteriorate - as they did as a result of a different set of "peripherals" in the last EU Banking Crisis!

CONCLUSION

This problem is not going away quickly as Global liquidity rapidly disappears, unless the US Federal Reserve reverses monetary policy. This will happen but not before significant damage is done to EM Corporate Bonds and European banks & shadow bank lenders. Bond investors who are comfortable playing in the "BBB" and HY space have not been offered opportunities like like this in years.

Deutsche Bank and its massive derivative & swaps book should be seen as the "canary in the coal mine" for what is emerging!

This 20 Minute video supported by 43 slides further details the current situation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.