Emerging Problems in Emerging Markets

Last month we addressed investor concerns about slowing growth in China. This month we look at how trends in other emerging markets might affect Australian investors.

The core of the problem is that growth in emerging markets, which has been strong for a decade, is now slowing down, mostly because of the way that the China slowdown and falling commodity prices depress the value of commodity exports from low income countries. Although GDP growth in the developed economies remains stable (albeit uninspiring) at 1.6% pa in aggregate, growth in emerging markets has been falling steadily for the last three years. The absolute level at present is still 4.1% pa, but the downtrend is clear.

Should we fear a re-run of the 1997 Asian crisis? No, because the Asian economies involved have made sure that they don’t have the same risk exposures this time around. The 1997 Asian crisis was triggered by high levels of USD borrowing by companies in Thailand, Malaysia and other east Asian countries. When local borrowers had difficulty repaying their USD debt, their local currencies fell against the USD, making the problem even worse. This time around, thanks to better regulatory oversight, foreign currency borrowing is much lower, and most of the countries involved have built up significant foreign exchange reserves as a precautionary measure.

Should we fear a re-run of the 1998 Russian crisis, which ruined Long Term Credit Management and led the US Federal Reserve to intervene to prop up the US financial system? Russia now is a lot smaller and less important than it was then. We tend to think of Russia as globally important because of its past role as a nuclear superpower. In 2014 Russia’s GDP was only USD 1.86 trillion, ranking it at number ten in the global league tables, after India and before Canada according to the World Bank, and equivalent to only 2.4% of world GDP of USD 77.87 trillion. The state of California, by comparison, is much more important: its 2014 GDP was USD 2.31 trillion. The current recession in Russia is unpleasant for Russians, but of no importance for the rest of the world because Russia’s exports are mostly oil and other commodities. (In the GDP league tables Australia comes in at number twelve with GDP of USD 1.45 trillion.)

But there are many other low-income and middle-income countries whose economies have been buffeted by the collapse in commodity prices. In its October 2015 Global Financial Stability Report, the IMF warned that emerging markets should prepare for an increase in corporate failures. In the last year, the resources giants Glencore and Petrobras have seen their share prices fall 60%-plus, and there are plenty of similar examples among Australian resource companies. Brazil and Russia are already in recession, and last year’s oil price slide has driven the oil producer Saudi Arabia to repatriate more than USD 50 billion from its overseas investment portfolio.

It is clear that investors are taking emerging market risks seriously. Capital flows to emerging markets turned negative in late 2014 for both bonds and equities, and current trends suggest that 2015 may be the first year of net capital outflows since the 1980s.

For Australian investors who have no exposure to emerging markets, all this turmoil might seem irrelevant. But the global economy and global financial markets are very much interconnected, so recessions in emerging markets do have an adverse impact on the economies of the developed world. First, they  reduce demand for the exports of the developed world, which tend to be goods and services with high value added, such as expensive cars, airplanes, information technology, pharmaceuticals, medical instruments, telecommunications equipment, sophisticated machinery, and complex services such as insurance. In short, if a low-income economy is suffering falling exports or a falling currency, it cannot afford to buy as much from rich countries.

A second effect works by making the exports of low-income countries cheaper as their currencies fall. Cheaper exports tend to displace competing goods made in rich countries, whether in their home markets or in export markets. Neither of these effects has much impact on the US economy, because the US is much less dependent on trade than most other developed economies. In 2014 US exports accounted for only 14% of GDP and imports only 17%, well below the levels typical of developed countries.

The fact that many of the largest listed US companies are transnational companies suggests that problems in emerging markets should have a negative impact on the US share market, but data deficiencies make it difficult to estimate how serious this impact might be. It is true that global sales accounted for 47.8% of total sales of S&P500 companies in 2014, according to S&P Research in July 2015. But this figure conceals wide variations: 186 of the 500 companies had zero foreign sales, 46 had 0% to 15%, and 22 had more than 85%. The limitations of the reported data meant that 22.2% of total sales were simply ascribed to “foreign countries” without any regional detail – that is, we don’t know which countries nearly half the sales went to. Nor do the statistics capture change of domicile by companies.

In addition, the term “global sales” does not distinguish between exports from the US, local sales by a subsidiary operating in a country, and intracompany “sales” between, say, Australia and a nearby jurisdiction which just happens to have low tax rates. These three forms of “global sales” have very different implications in the real world. Export sales may rise or fall depending on exchange rates; sales by in-country operations are a matter of foreign currency translation; and the level and location of intracompany sales are decided at the discretion of management. As a consequence of these holes in the data, the aggregate effect on the S&P500 is impossible to calculate – the best we can do is identify the individual companies which are most or least affected. For example, the US equipment maker Caterpillar generates 60% of pretax profit outside the US: its sales have been falling since 2012, and it has closed 20 plants outside the US.

For financial markets, the most important consequence of recessions and falling currencies in poor countries is that the companies in these countries find it harder to pay the interest and principal on their debts. This effect becomes much more severe if the debts are denominated in foreign currencies rather than local currencies. Nonetheless, any large default causes problems locally and globally. The local consequences are obvious – job losses, flow-on insolvencies, and GDP losses which are not easily recovered. The consequences for financial markets follow from investors’ losses of principal or interest, which motivate investors to re-appraise and re-price the risk in corporate bonds. Credit spreads will widen, making debt more expensive for risky companies at the same time as it becomes cheaper for “safe havens” such as US government debt and top-rated companies’ bonds. The re-appraisal of corporate debt risk will eventually flow through to equity investors’ perceptions of these companies.

The implications for Australian investors are straightforward. We continue to favour the US and Europe, and to avoid all Asian markets. We expect that the resources sector will continue to underperform, and all companies with global operations should be assessed on a case-by-case basis for their exposure to emerging markets. As we noted last month, the short term outlook for China is not as bad as global investors seem to think it is, and this view has positive implications for the Australian share market. Investors who are not risk averse could look at opportunities in Australia outside the banking and resource sectors.

Neill Colledge

November 2015

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