9th October 2015

In the Dreamworks movie “Madagascar 2”, there are many parent-intended lines uttered by the Lemur King Julien. One of his best is when they are leaving the African island of Madagascar on a plane, flown by the Penguins, bound for New York City. King Julien of Madagascar (self proclaimed) wants to know why people from the other end of the plane keep coming into the first class section;   “Maurice, whatever happened to the separation of the classes?”. The new Chief Economist of the IMF, Maurice Obsfeltd, answers this question in a recent report and the findings all lead back to New York City indeed; the Federal Reserve. A pending US interest rate rise is going to separate the developed and emerging economies in a way that may lead to unforeseen circumstances.

Maurice’s report was of course the IMF’s bi-annual Global Financial Stability Report. The IMF runs a series of simulation models which attempt to plot the outcome of the already-concerning emerging markets (‘EM’) growth profiles upon global growth. Shocks that may originate in EMs have, according to the IMF, the potential to amplify into “global asset market disruption and a sudden drying up of liquidity in many asset classes”.

What is the scenario that the IMF sees could precipitate an Emerging Market “situation”? Not much at all has to happen, so it seems. The incremental creep of risk premiums increasing, a few more corporate defaults and a global slowdown in demand for risk assets.

Should the IMF’s simulations eventuate into reality, it implies global growth potentially falling below 2%, currently forecast to be 3.1%, already revised down recently from a prior 3.5%. So, 2% is, as the IMF goes to some lengths to stress, not a crisis, not a repeat of the GFC. However, it does leave policy makers with all policy levers almost set permanently at “really low” interest rates, thereby having nowhere to stimulate from, should the need eventuate.

When market commentators talk about EMs, they are talking about so much more than yesterday’s heroes, the BRICs. There are 837 stocks from 23 countries in the MSCI Emerging Market index. These countries for the sake of clarity are: United Arab Emirates, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, Indonesia, India, Korea, Mexico, Malaysia, Peru, Philippines, Poland, Qatar, Russia, South Africa, Thailand, Taiwan and Turkey. Of those 837 stocks from these countries, when you apply any type of “asset quality” filter in the attempt to strip out companies with material exposure to commodities, domestic banks, family run businesses that own lots of different things, Chinese companies with enthusiastic earnings projections, all Greek companies, all Russian companies, companies from any African nations whose GDP relies on commodity exports, then you are left with a Hobbit’s handful of companies. Like probably less than 40.

If the corporate defaults emanate from China, then the UK is expected to be affected through its GDP’s reliance on financial services, manifesting in a China-led downturn scenario through UK based banks with significant exposure to Asia, namely of course HSBC and Standard Chartered. China of course has in recent weeks lowered its required reserves ratio for its banks to free up capital on their balance sheets, another policy lever that the PBOC likes to invoke in times when they believe the economy needs stimulation beyond the interest rate going down even further.

Last week Ghana accepted 10.75% to raise another 1 billion USD. It had hoped for 10 years at 8.25% which is what it borrowed at last year, but not to be, mon ami – maturity is now 15 years and you’re paying 250 basis points more! Unlucky.

The IMF, even before Maurice came on board, has repeatedly warned African governments about risks they faced with the over issuance of debt. Ghana is now a cautionary tale for emerging economies that rely on natural resources. Maurice & Christine have lent them $1B already since the commodities downturn ensued last year (2014).

Nigeria and the Ivory Coast both need to issue more debt to balance their budget next year.

JPMorgan had removed Nigeria from its emerging markets bond index due to 2024 US dollar denominated bond yields having risen from 5.35% last year to over 8% currently.

Looking at the country who thinks it will eclipse China in the next 20 years, bad loans from steel and power projects in India are currently estimated to exceed $23 billion, with at least 5 of the top 10 private steel producers under “severe stress”.

It would be remiss of me not to address to the commercial viability of Communist led Greece now that Tsipras has conquered the German led conservatives in Brussels: Greek non-performing loans have risen from 33% to 50% in the 3rd quarter of this year.

The fall of Glencore (down some 70% in the past 12 months) has recently led an institution no less hallowed than the Bank of England, to ask certain British financial institutions to reveal their exposure to commodity traders and prices of raw materials, given the recent fall in prices of many constituents in the commodity baskets. The BoE has emphasised that this concern was not borne of any immediate concerns, but rather it just wanted to know if those companies requested, knew what their level of exposure was. Does anyone remember the VaR measure from the GFC? Here we go again.

So what threat are these 23 countries really to the developed world economies? In truth, it is the need for a strengthening US economy to begin to operate in an interest rate environment that even looks like it is approaching normal. As mentioned earlier, one of the greatest threats that the Fed and IMF are cognisant of is that if global growth slows, they must have room in their monetary policy settings from which to cut, so to foster further economic growth. Yet, the doves say that raising US interest rates may set off an emerging markets rout. We were correct in our own modelling that the US Federal Reserve would not raise rates in September 2015, and will most likely not do it in calendar 2015. However, the Fed is approaching its own inverted version of stall speed and the fate of not just the “first class” world depends on the timing of the inevitable implementation.

Financial Times
US Federal Reserve

Marcel von Pfyffer


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