Global liquidity risks

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Paul Lamacraft 22 August 2014 Est. reading: 3 min read

We recently had a meeting with Julien Garran, Global Commodities & Mining Analyst at UBS. We share Julien’s focus on long-term risks and returns rather than short-term forecasts.

We aren’t invested in the mining sector currently but it is a big part of the UK market and we regularly revisit it to ensure that our stance remains appropriate. Julien also has a very convincing view on the importance of global liquidity in determining the performance of emerging markets and, in particular, China.

As the chart below demonstrates, capital flows have driven every major turning point and every major trend in commodities for the past 30 years. Currently, global liquidity analysis suggests that emerging markets face a challenging future in the near term.

Source: Bloomberg

Garran explains: “When money flows into emerging markets it acts as a catalyst for aggressive domestic money creation there, and strong commodity intensive growth. The danger we see is that the three major drivers of capital flows; the Fed, the US current account deficit, and the commercial banks – are all moving in the wrong direction.”*

The Fed has almost completed its tapering of QE as unemployment falls and as concerns mount over credit overheating and income inequality. Meanwhile, through its current account deficit, the US has been providing plentiful liquidity to the rest of the world for the last 30 years but this is beginning to change. A combination of the shale boom and onshoring (the opposite of offshoring, whereby corporates bring previously outsourced services back into the US in response to the weak dollar) has reduced the US current account deficit by 1.5% over the past two years. UBS expects the deficit to shrink another 1.5% over the next three years, further reducing flows into emerging markets.

And lastly, commercial banks, constrained by Basel 3 rules, have sought to boost income by gearing up to buy treasuries & credit. That has induced fund managers to reach for yield and send money overseas. But the regulators are concerned, and UBS believes that new rules will put pressure on investment banks to reduce balance sheets over the next three years.

All this will continue to induce outflows from emerging markets over the next two-to-three years.

Garran suggests that this is happening at a point when the emerging markets are more in need of inflows than at any time since 1998. “After 14 years of capital inflows, credit growth and booming investment, emerging markets are facing diminishing returns and struggling with their own large current account deficits. They need strong capital inflows just to stop domestic credit tightening. Outflows would threaten tight credit and an investment bust.”*

Of course, the economy that is likely to be most affected by these developments is China. We are concerned, as is Garran, that China is now facing a solvency crisis, after the extraordinary 2009-11 boom. “In just three years from 2009-11, China doubled lending, it doubled fixed capital formation, and it used more cement than the US did in the whole of the 20th century”, Garran explains, “But it is now suffering from misallocated capital; falling returns and bad loans. The focus of the problem is the property sector.”*

Data from CNIEC shows that China housing sales are down 8% year-to-date, housing starts are down 15% and property developers have bought 40% less land. That itself is a problem, because local governments rely on land sales for 40% of their income.

“The Chinese authorities are concerned about property, and they have put in a mini-stimulus to prevent too sharp a slowdown.” Garran continues, “That’s showed up in an improvement in infrastructure activity which may support growth over the next few months. But as this mini-stimulus fades we would expect the underlying weakness in property to again take centre stage.”*

This re-emphasises our views on China. Since the financial crisis, China has been a key engine of global economic growth but, like elsewhere, the growth has been artificially engineered through stimulus which simply stores up trouble further down the line. China is now looking increasingly fragile, in our view. This, coupled with the impact of Fed tapering on global liquidity, provide further evidence to vindicate a cautious investment strategy. We remain positive on the long-term prospects for the portfolio, but fear that some parts of the market look vulnerable to these risks.

* Source: UBS Mining & Commodity Q&A research notes: Four Horsemen (7 January 2014); Dollar Bill (20 January 2014); Cash or Carry (6 June 2014).

What are the risks?

  • The value of the fund and any income from it may go down as well as up, so you may get back less than you invested
  • Past performance cannot be relied upon as a guide to future performance
  • The ongoing charges figure is charged to capital, so the income of the fund may be higher but capital growth may be restricted or capital may be eroded
  • The fund may invest in other transferable securities, money market instruments, warrants, collective investment schemes and deposits – some of these security types could increase the fund′s volatility and increase the level of indirect charges to which the fund is exposed
  • The fund may invest in overseas securities and be exposed to currencies other than pound sterling – as a result, exchange rate movements may cause the sterling value of investments to decrease or increase
  • The fund may invest in unquoted securities, which may be less liquid and more difficult to value, because they are generally not publicly traded – the lack of an open market may also make it more difficult to establish fair value

Important information

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