The butterfly effect

  • Written by 

    William Hobbs, Hao Ran Wee, Christian Theis, Q4 2015

  • 12/10/2015

“Who was blowing on the nape of my neck?” David Mitchell (Ghostwritten)

Is China’s ongoing economic slowdown in the process of unleashing economic chaos on the rest of the world? We explore some of the varying ramifications for different parts of the emerging markets space and the developed world in a little more detail below.

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Market turmoil

Ripples from China’s ongoing economic slowdown have become significantly more visible in the world’s capital markets in the third quarter. Already battered commodity markets have plunged further, while August saw developed equity markets give up all their year-to-date gains and more in a series of stomach churning falls. Emerging markets equities are now well down on the year in both local currency and dollar terms, capping off a poor couple of years for the sub asset class. A growing legion of, admittedly perennial, doomsayers are now more loudly suggesting that we are now witnessing the end of this elongated but timid global economic expansion. Economic chaos will ensue, though this time the monetary arsenal of the major developed markets central banks is surely exhausted.

Our suspicion remains that there is further to go in this economic cycle. Even if a more abrupt slowdown is already in motion in China, we see the US economy, and more specifically the US private sector, as capable of keeping the show more or less on the road for the world economy for a little while yet (Figure 1). This still means that within a balanced portfolio diversified across asset classes and geographies, we suggest clients with sufficient risk appetite tilt exposure towards developed equities in particular. Even after our move to tactically underweight emerging markets equities (11 March 2015), portfolios contain a strong strategic leaning to the asset class, indicative of our still present belief that the long-term prospects for emerging markets equities remain attractive.

FIGURE 1 shows Private sector cash flows. FIGURE 2 shows World Bank poverty reduction

China – Exit the dragon?

For many of the world’s gloomiest professional commentators, China has long been the thing to worry about. Massive and growing debts, an unsustainable dependence on investment for growth and the increasingly uncomfortable mix of an at least partially market-driven economy combined with the growing concentration of political power all vie for the top spot in the list of investor concerns. Those predicting (some with a little too much glee) a hard landing for the Chinese economy have recently been reinvigorated by a further deterioration in some of the indicators, some unofficial, that investors around the world tend to scrutinise. This deterioration alongside the People’s Bank of China’s decision to, somewhat conveniently, choose this moment to talk about allowing the market a greater role in setting the direction of the currency, has provoked wild commentary about the end of the cycle/world and violently disturbed the peaceful summer repose of Western capital markets.

Our more sanguine view of some of the risks facing China is primarily based on the potential for consumption to play a still larger role in the economy, in the process helping to smooth over some of the cracks appearing elsewhere. Of the major emerging economies, China’s success in reducing absolute levels of poverty and broadening its middle class over the last few decades stands more or less alone (Figure 2). As a result, the consumer now plays a more dominant role in the economy than previously, in line with the Chinese authorities’ stated aims (Figure 3).

FIGURE 3 shows the Breakdown of Chinese GDP and FIGURE 4 shows the Keqiang Index versus real GDP

However, this continued strong growth in consumption is coinciding with an increasingly visible slowdown in other parts of the economy. An oversupplied housing market is understandably deterring further construction, which in turn is taking its toll on heavy industry. For some time, those worrying that a more chaotic economic slowdown is already in progress in China have pointed to alarming declines in electricity consumption and freight volumes in particular. In concert with bank loans, these statistics form what have come to be known as the Li Keqiang Index, seen as a proxy indicator for Chinese growth (Figure 4).

We’ve long made the point that such indicators more likely speak eloquently of the old economy characterised by heavy industry than of an economy that is moving increasingly towards services and consumption.

There can be no doubt that China is slowing, the debate is really as to the pace of that slowdown and what it means for the rest of the world. For the moment, we see insufficient evidence that China’s economic growth is collapsing. We are also yet to see alarming signs of stress in interbank or credit markets (Figures 5 and 6).

What does it mean for the rest of the emerging markets?

Some of the most prominent stresses across emerging markets economies right now are understandably linked to net commodity exporters such as Brazil, Russia and South Africa. Commodity prices have plunged lower over the last few years, with oil prices joining the fray in the middle of last year (Figure 7). While high commodity prices clearly helped conceal some of the structural and institutional problems that continue to dog these economies, the more recent commodity price declines have laid them bare.

It is hard to overstate China’s role in all of this. Previously a dominant buyer in most of the major commodity segments, with the construction boom having peaked, many of these commodities now look significantly oversupplied. Some of this oversupply is now significantly closer to being worked off but a fresh boom in commodity prices seems unlikely in the immediate future.

FIGURE 5 shows the China repo 1-week rate and FIGURE 6 shows the China CDS spread 5 years

To add further to this strain, some of these same net commodity exporters are home to companies that have borrowed recklessly in dollars over the last several years. Higher US interest rates are unlikely to be helpful here. Such problems for the wider emerging markets space are likely overstated however, with much of the debate lacking proper context. Much of the borrowing is matched by dollar assets and the level of external debts still looks manageable (Figure 8) in most cases, particularly when set against the late 1990s. This time, better macroeconomic policymaking, stronger institutions and better risk management – evident in longer debt maturities and reduced net foreign currency exposure – mean emerging markets should be more resilient to a US monetary tightening cycle.

Keep in mind that not all emerging markets are net commodity exporters either. India, for example, imports 75% of its oil consumption, and currently stands as the world’s fourth largest net importer of oil. The disinflationary effects of low oil prices are allowing the central bank to ease monetary policy, while simultaneously allowing the Indian government to cut fuel subsidies, lower the fiscal deficit and focus on longer-term structural reforms.

Other commentators have focused on how a Chinese slowdown would negatively impact East Asian countries that export to China. This gloomy spotlight has recently been trained on a slump in South Korean exports, often seen as a reliable bellwether for global trade – of which a quarter goes to China. August trade data from Taiwan showed a similar sized drop in exports, with shipments to China falling by 17%.

FIGURE 7 shows the Bloomberg Spot Commodity Index and FIGURE 8 shows the Net external debt

However, a closer look at the data reveals a more benign conclusion. For one, the slump in South Korean exports was driven primarily by lower oil prices – the export value of petrochemical products declined while demand for ships used for offshore oil development obviously weakened. On top of this, the tragic industrial accident at the Port of Tianjin in late August further disrupted China’s export shipments. All in all, the recent trade data from South Korea does not necessarily imply a negative outlook for the global economy as most seem to be arguing.

It is also worth noting that while China is the primary export market for many emerging countries, particularly those in East Asia, much of this is intermediate goods, which end up heading to the developed world after assembly. The US remains the elephant in the room in emerging markets exports, both in direct and indirect terms (Figure 9).

Figure 10 illustrates that US imports have tended to move in concert with economic growth, a factor that is central to our belief that a pick-up in US and developed world economic growth is likely to be helpful in papering over some of the economic cracks appearing in emerging markets.

FIGURE 9 shows exports of East Asian countries as a percentage of GDP and FIGURE 10 shows US import growth versus GDP growth


Those confidently predicting that the Chinese economic slowdown will drag the world economy into whatever abyss it is inevitably heading into may be guilty of tunnel vision. That’s not to say that a hard landing for the Chinese economy could not disrupt this already elongated economic cycle – of course it could. However, if, as we expect, the US economy accelerates into the end of the year, with a consumer buoyed further by a strong jobs market, rising real wages, low gas prices and an easing credit backdrop among other things, we suspect that the resulting economic warmth will spread in varying lags to emerging markets.

The tactical picture for emerging markets assets remains clouded, particularly as we await more detail on the likely trajectory of US monetary policy over the coming years. However, the strategic argument for some ownership of emerging markets stocks and bonds remains strong, based as it is on emerging capital markets moving over time to more accurately reflect the growing contributions of emerging markets to the global population and output (Figure 11).

FIGURE 11 shows Asia’s weight in the world