Note: in the first article in this series, Adrian Day discusses impending tapering by the Federal Reserve and its potential effect on U.S. markets. A third article discusses gold and precious metals.
Globally, the picture is similar to the situation in the United States, with slowing economic recoveries, rising inflation, and for the most part central banks—and governments—without dry powder to fight any slowing. Interest rates are low and negative in much of the world, while fiscal policies have little room to expand after widespread spending abandon during COVID lockdowns. Many smaller banks, particularly in Eastern Europe and Latin America, are already raising rates, but the world’s major banks are hesitant to follow.
Europe’s growth slowing due to high energy prices
Europe had a strong economic recovery from very sluggish levels, with large government deficits. But now the recovery is dramatically slowing. Europe is heading into what analyst Larry McDonald calls an “ESG recession,” sparked by widespread “clean energy” policies (the ban on fracking in the U.K., for example, despite the discovery of large natural gas reservoirs). These policies have consequences, even if most politicians don’t look beyond the latest opinion polls while the intellectual class applauds.
"For the most part, emerging markets did their fiscal adjusting a decade ago and are now rebounding."
If energy prices are going up dramatically, with shortages throughout Europe (most notably in the U.K. and Germany, where gas prices have soared 421% and 170% this year respectively), it’s obviously something to do with those nasty "Ruskies." No one thinks of the ESG restrictions on traditional energy sources, nor the massive money printing that leads to all prices going up.
Inflation is also picking up across Europe; for the Eurozone, September CPI was up 0.5% month-on- month, and it was not an anomalous month.
China slowing while emerging markets stronger
China is also slowing, though from a higher sustained rate of growth, as the real estate market is cooling, and exports beginning to slow. The largest real estate developer, Evergrande, has now missed two scheduled debt payments and may fail; it has only kept going for a year or so by infusions of new money. An Evergrande failure will hurt Chinese real estate and may spread to the whole economy by causing cautious banks to reduce lending.
"Commodity exporters have strong current account surpluses and balance sheets, and virtually no dollar debt."
Chinese banks—generally—are undercapitalized after years of expansion, and frequent forgiveness of interest on loans, adding amounts to principal and thus exaggerating the loan to capital ratio. In response, the People’s Bank may actually cut rates again, even though growth is still the highest of any major economy in the world.
Though Evergrande’s failure would be a major event, so far it appears that banks in Europe and North America have little exposure to Evergrande and other at-risk Chinese developers, though some in Asia do.
Emerging markets, on the other hand, have already been raising rates. For the most part, emerging markets did their fiscal adjusting a decade ago and are now rebounding. Commodity exporters have strong current account surpluses and balance sheets, and virtually no dollar debt, having learned a hard lesson in the Asia crisis of the late 1990s.
Some, however, are still struggling with COVID, while commodity prices have different effects, depending on whether the country is an exporter or importer. In Brazil, to take an example, the economy is rebounding but inflation is also increasing. The central bank has increased rates from 2% to 5.5% over the past six months to get in front of inflation, and more increases are expected.
"[T]here is a shift from the U.S. from high growth to value and global markets, particularly in emerging markets; value has outperformed growth in these markets nearly 80% of the time."
Overall, however, in most countries, growth is slowing at the same time that price inflation is picking up. The combination—stagflation—is the worst of both worlds for the economy, positive for gold (vide 1970s), and possibly positive for stocks depending on whether the central banks fight the “stag” with easy money or the “flation” with higher interest rates.
Chinese stocks fall on regulatory crackdowns
In China, the continuing regulatory net has been cast broadly (tech, ride sharing, private education), and certainly broader than national security concerns (the original rational). The market is down 16% in the last seven months, and they are threatened from both sides in an increasing war of words with the U.S.
In addition to the Chinese crackdown, there are fears of U.S. restrictions on listings, with the SEC insisting Chinese companies open their books to U.S. auditors.
Many ADRs do not represent actual ownership in the companies but are more like tracking stocks, and these so-called Variable Interest Equities (VIE) are particularly in the crosshairs. However, most of the bad news is already reflected in stock prices, though extreme care and selectivity is required.
In sum, major markets around the world are expensive and the risk of a near-term pullback has increased. At the same time, there is a shift from the U.S. from high growth to value and global markets, particularly in emerging markets; value has outperformed growth in these markets nearly 80% of the time. We are cautious but always looking for good companies at reasonable valuations.
Adrian Day, London-born and a graduate of the London School of Economics, is the founder of Adrian Day Asset Management. His latest book is "Investing in Resources: How to Profit from the Outsized Potential and Avoid the Risks."
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