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In the animal kingdom we may be headed into the season of hibernation for the bear, but in the world of the stock market the bears were out in full force in the past two months. After global stock markets fell by over 6% in August, fears were elevated coming into the dreaded September as worries that the global economic slowdown of the past few months would deteriorate into a full blown recession caused a greater sense of urgency to get more defensive about stock holdings. Investors once again looked to the U.S. Federal Reserve to ‘sweet talk’ the market into better conditions by making more ‘dovish’ comments about being more ‘data dependent’ when it comes to raising interest rates. After the September 17th Fed meeting ended and the decision was to leave interest rates unchanged, stocks briefly continued a rally that had started earlier that week in anticipation of such a decision. However, the key new reason the Fed declined to raise interest rates was “recent global economic and financial developments.” This concern about growth in China and its impact on global financial markets, a new factor in their decision-making, spooked the markets even further and sent them lower over the following week.
The Fed announcement raised the growing concern that a world recovery can no longer count on a big assist from fast-growing economies in the emerging markets. Our view is that the world has lurched into a new and dangerous stage of its long-running financial crisis, as slowing growth in China and other developing countries create bigger challenges ahead for the global economy. International trade is shrinking and China’s stock market plunge has reawakened fear of a hard landing for the Asian giant’s economy. A widespread slowdown is already under way as export volumes are plummeting around the world. An economic headwind is reflected in the falling trade figures, which are in their worst downturn since 2008. The drop in trade was caused by the commodity price crash which had crimped incomes in commodity exporters – mainly emerging markets but also advanced economies like Canada and Australia. Those countries import less from advanced economies like the G7 and China. The commodity price drop will reduce global GDP growth this year and the drop in world exports predicts that things are not going to work out well for the global economy in 2016 either.
Emerging economies are clearly facing an extremely critical and risky period in their evolution which brings to mind prior periods of crisis in the 1990s. In the first phase of growth in emerging markets, before 2008, developed economies borrowed at a hectic pace, partly to consume and invest in the developing economies goods and commodities. In the second phase—2009 to 2011—deleveraging Western consumers were replaced by a hyper-leveraging China, and by global investors eager to lend to faraway companies rather than accept near-zero interest at home. Bond issuance by emerging-market corporates more than doubled since 2009, to $2.4 trillion. All the stages in the crisis have followed broadly similar patterns. They start with international investors pouring money into a region or sector. That “surge of global liquidity” inflates the prices of real estate, stocks and other assets, and spurs expansion. But those powerful props have now fallen away. China tightened its stimulus tap, and growth is slumping there, from 7.8% in 2013 to an expected 6.8% this year and 6% in 2017, according to the IMF. China’s arrested development is visible in dozens of so-called ghost cities that were thrown up during the frenetic boom years and now await inhabitants. China’s slowdown, combined with subpar recovery in the U.S. and Europe, has slashed demand for the wares of other developing countries. Emerging-market exports have stopped growing after posting 10% to 20% annual gains throughout the 2000s. The raw growth that cleansed all sins in times past has tapered significantly. Average economic expansion for developing countries has fallen below 5% annually, from 8% in 2007. Their growth advantage over developed economies is at its lowest since 2002—about 2.5 percentage points.
The result of this economic slowdown is that sentiment on stock markets in the Emerging Economies has reversed with a vengeance. Over the past year, $300-billion of capital has flowed out of emerging market economies. Bond yields have shot up in emerging economies, growth projections have tumbled and currencies have weakened. It is simply too soon to tell how potent contagion from emerging markets to the world economy will be. Reduced demand will undoubtedly hurt trade, but an even greater danger is that distress in China and other emerging markets will expose unexpected weaknesses and could destabilize the global banking system. The result is that Emerging-market equities have crashed by 20% over the past year after treading water for two years, as measured by the widely held iShares MSCI Emerging Markets exchange-traded fund (ticker: EEM).
