Emerging markets and China have been the primary driver of global growth in the years since the GFC.
When the developed world fell into a dark economic hole and spent years crawling out of it, emerging economies bought and sold everything from jet airliners and raw materials, to college degrees and holidays for their rising middle classes. That has helped keep the global economy, as a whole, above water.
In parallel to this, advanced countries that felt the full brunt of the crisis turned to central banks to reinvigorate their economies through low interest rates. This has meant emerging markets have had access to cheap money.
With the US Federal Reserve now poised to start raising interest rates, probably in two weeks, things are going to change.
The big question for investment strategists – and for the global economy – is what it will look like and what might get exposed in the process.
For emerging markets – the catch-all phrase for developing nations including the world’s second-biggest economy, China – there are some significant problems.
Debt has been soaring, and particularly in Asia. And the cost of servicing a lot of that debt looks like it might start to rise just as China is slowing down.
Problems in debt markets have a record of being at the centre of the seismic events. While they’re not always the most exciting markets to look at, they are always worth some thought. Witness the GFC and the Asian crisis, both fundamentally caused by the ability to meet debt repayments disintegrating on a systemic scale.
The availability of cheap money has meant leverage across corporations in emerging markets Asia has risen by close to 50% against pre-GFC levels. Here’s the chart, via Soc Gen:
While the appetite for borrowing in emerging markets is clearly waning, Soc Gen’s fixed income strategists say this spells trouble.
Companies in emerging markets – think South East Asia, the Middle East, and South America – have reaped the benefits of China’s incredible boom over the past 20 years as demand for their raw materials have surged.
But now the sheer amount of leverage on the corporate balance sheets – and this is mainly the case in Asia – make them vulnerable to both the economic slowdown in China and a return to rising global interest rates. And this could lead into a vicious cycle in which investment budgets among companies in emerging markets start to get cut too, putting further downward pressure on growth prospects. Here’s Soc Gen (the italics are theirs, the bold ours).
At best, debt trends are now flattening out, turning off a major engine of EM capex (and global growth). The last IIF EM bank lending survey showed that lending standards are the toughest they have been in more than four years. At worst, the rise in corporate defaults, already in the making and will start to lead EM corporate spreads wider. This is our view for H1 16 (see EM/Credit section). So far, EM corporate spreads have been well behaved, thanks to government support in China … and the quest for return. This may be the next shoe to drop, in which case the whole EM complex will stay wobbly.
“Wobbly” is probably one of the more polite words available for that scenario.