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).